LDI – Debunking the myths
Consider the entire range of solutions when embarking on a discussion around LDI strategies…
In the South African pension fund world, the term ‘liability-driven investing’ (or simply ‘LDI’) has, unfortunately, become synonymous with a very narrow interpretation of the concept of liability matching. It has almost exclusively been linked to investments in inflation-linked assets, either directly through purchases of physical index-linked bonds (ILBs) – including government ILBs, bank replica bonds, corporate ILBs, structured deposits and infrastructure assets – or indirectly through derivative instruments producing an inflation-related pay-off.
Johan Kriek, Head of Liability-Driven Investments at Sanlam Investments explains all the different applications offered by LDI and debunks some of the narrow interpretations.
This narrow focus has had some adverse consequences and may have led to the implementation of sub-optimal solutions where the fund’s requirements have not been fully considered when implementing a solution. In particular, when focusing on inflation-linked assets only, pension funds are forced to compete with large financial institutions (including life insurers and banks that are forced to hold these assets to meet stringent capital requirements) for access to these assets. This structural demand, along with a limited supply, has artificially inflated the price of these assets relative to others which, when using the wider and more appropriate interpretation of LDI, can be used to implement very effective LDI strategies.
The range of LDI solutions
When considering LDI strategies, we firmly believe that trustees should consider the entire range of solutions available to ensure that a solution that meets the unique characteristics and needs of the fund is selected. At a high level, the range of LDI solutions that are available is shown in the diagram below:
Source: Sanlam Investments, 2016
When starting on the LDI journey, funds are often at the bottom left point, having a balanced fund strategy (either through combining a number of balanced managers or through a strategic asset allocation implemented using specialist managers) with no cognizance of the characteristics of the liability being taken. While one expects balanced fund returns to be sufficient to meet the pension promises over long periods of time, it can be a volatile ride in the short to medium term with significant fluctuations in the funding level. In addition, the increased focus on including pension fund benefit costs in the financial statements of the fund sponsor has led to fund sponsors increasingly urging pension funds to implement LDI strategies to mitigate this volatility and the associated impact on earnings.
Absolute return funds in an LDI context
One investment strategy that is seldom seen as forming part of LDI, probably due to its lack of incorporating interest rate sensitivity, is absolute return funds. However, we do believe that it is certainly worthwhile including these funds in a discussion around LDI strategies. In instances where the fund trustees and sponsor are not too concerned about short term volatility in the funding level, but would like the assets to have a more explicit link to the inflation-linked payments to be made to pensioners – absolute return funds, with their explicit inflation target and focus on downside protection – certainly have a role to play.
Removing interest rate risk without buying inflation-linked assets
In a previous article, we illustrated how dynamic hedging solutions offer the best of both worlds – ensuring funding level stability while maintaining full economic exposure to growth assets. Dynamic hedging is the LDI strategy that can provide funds with the highest level of upside return and hence the highest level of expected pension increases (through full economic exposure to growth assets) while removing the entire interest rate sensitivity and ensuring funding level stability. Furthermore, these strategies rely on nominal bond yields to achieve the interest rate match and hence do not force funds to compete with large financial institutions for a limited supply of inflation-linked assets. As such it is a strategy that compares favorably in terms of the assets required to implement an LDI strategy under the prevailing market conditions.
The narrowly-defined status quo
The prevailing view on LDI in the South African market falls within ‘bucket hedging’ solutions. This incorporates solutions where inflation-linked assets are used to explicitly match either a portion of or the entire liability made up of inflation-related increases. Solutions in this space either remove all the risk (apart from mortality risk) by investing in a portfolio of South African government ILBs, or a portion of risk through matching only a portion of the liability profile. In addition, one is able to incorporate ‘alpha’ strategies by either investing in risk-bearing instruments with an inflation-linked return profile (typically infrastructure assets or bank replica bonds) or using derivative overlays to maintain the interest rate sensitivity of the overall portfolio while aiming to add excess return through (typically) investing the underlying portfolio in credit assets.
Annuity solutions as part of the LDI discussion
The final part of the LDI spectrum is an annuity solution offered by a life insurance company. These solutions make an explicit promise to pay the pensioners an inflation-linked payment for life and, as such, removes all the risk (including mortality risk) from the fund. We firmly believe that annuity solutions should form part of any discussion around LDI, not least because they remove the risk from the sponsor’s balance sheet, provides fund members with excellent benefit security and, perhaps surprisingly to some, require fewer assets to implement when compared to ‘bucket hedging’ solutions that do not incorporate alpha strategies (assuming a consistent valuation basis).
Conclusion
At Sanlam, we firmly believe that trustees should consider the entire range of solutions when embarking on a discussion around LDI strategies. There are a number of strategies that fall outside of the prevailing narrow definition of LDI that can add tremendous value to sponsors and pensioners alike. Failing to consider these would lead to sub-optimal solutions being implemented. While investment managers are incredibly skilled at ‘talking their own book’, it is, in our view, the trustees’ fiduciary duty to ensure that the best solution available, given the fund’s specific needs and circumstances, is pursued.
Related articles:
What is liability-driven investment?
Liability-driven investing (LDI): An effective risk management tool
Sanlam is an authorised financial services provider.
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