(This is a follow up to the Jargon Buster about Liability Driven Investment (LDI) strategies in the October edition of Tricio Monthly Insights. Please contact us at firstname.lastname@example.org for a complimentary copy.)
Richard Feynman, the Nobel Prize winning physicist, used to say that knowing the name of something is different from knowing something. It certainly applies to liability driven investment (LDI) strategies. Like many investment tools and techniques, there are both pros and cons in applying LDI in portfolio management. Something may work under certain market conditions, but then become highly damaging when these conditions change – especially in a manner not experienced before and not foreseen.
The gilt crisis brought LDI to the spotlight. Many commentators, experts and well-known fund managers analysed what went wrong. The CEO of Next plc described LDI as a time-bomb due to the leverage involved. And the often opinionated Terry Smith, chief executive of Fundsmith LLP, wrote in the Financial Times that pension schemes should have put more focus on return rather than the pension deficit (or the funding gap).
Both views have merits, even though there is some hindsight involved. What if the next pensions blow up is illiquid but high growth assets? There are reasons, rightly or wrongly, that pension trustees generally do not like uncertainty. Maybe the focus on the funding gap by accountants just supports the trustees’ fear about uncertainty.
But fear often leads to wrong decisions. Terry Smith thinks that pension portfolios should be focusing on long term growth. I will argue that the fear led to trustees thinking of LDI as a risk elimination tool. Sadly, that is not the case.
As pointed out in the October Jargon Buster, when a defined benefits pension scheme decides to run a deficit and underfunds, it is taking a risk. It is a risk as the scheme has now deviated from the set up that ensures future liabilities will be paid (using government bonds like gilts).
That risk may not be high. It depends on the size of the funding gap or deficit. Accountants draw the trustee’s attention to this deficit every year. Some trustees may think like Terry Smith and decide to manage the risk of missing future liabilities by allocating to risky assets with (potentially) higher long-term growth. They have now turned the risk in not meeting future liabilities to investment risk, as the success will be based on the risky assets selected, how well they perform over the long run, and (crucially) the skills of the manager who makes the selection and allocation. You manage that pension deficit risk by turning it into an investment risk that can be managed by yourself or another investment professional.
But many trustees do not think like Terry Smith. Their priority is to maximise the chance of meeting future liabilities by making sure the funding gap does not rise, which happened when bond yield kept going lower and lower through central banks’ quantitative easing. When experts and banks came in and presented LDI as a way to hedge this deficit, the strategy looked very appealing.
In any hedging, you rely on another instrument or tool that provides you with the required payout in managing the risk. In LDI, the payout is achieved through a synthetic long position in gilts. This synthetic position can be created by taking out a loan to buy gilts, borrowing gilts (so-called repo arrangements) or through interest rate swaps. These are leveraged as a loan is involved, where the pension scheme pays interests which is often linked to short-dated interest rates. And a loan is needed because the pension scheme does not have enough money to buy the actual gilts.
So what the pension scheme has done is to change the risk of not meeting future liabilities over the long term to another form of financial risk: impact of interest rate movements on the loan. Again, the risk in not meeting the liability is transformed to something that looks manageable. The trustee may think the liability risk of the pension has been ‘hedged’. Instead, LDI transforms that risk to risk on the loan interest (which was going up this year) and also on the price of the underlying instruments, gilts, that are also used as collateral to support margin calls.
Ultimately, we probably should admit that we are terrible in pricing risks that occur way into the future, like whether the current assets held in a defined benefits pension can meet future liabilities. That risk may not be as high as we think, especially since some risky assets like equities have demonstrated historically that they can deliver good returns over a long term.
James Chu CFA
Head of Investment Solutions