Time to shift gear on LDI

In unpredictable, low-return markets, defined benefit (DB) funds have never been under greater pressure to manage their assets in a way that ensures they meet their members’ pension liabilities. Volatile markets mean making the right calls is tougher than ever before, says Andrew Rumbelow – Institutional Segment Head at Sanlam Investments.

Volatile markets and unpredictable returns
The past 10 – 15 years have been a golden era for South African investors as they have enjoyed solid real returns, regardless of the asset class invested in. Looking forward, however, this is unlikely to be repeated given that a number of the elements driving performance over this period are no longer in place.  We are coming out of a period of structurally low interest rates due to the MPC’s inflation-targeting regime, along with a re-rating of our equity market to the levels of our emerging market peers.  This, combined with the global economic backdrop, leads us to believe that we will be in a low-return environment for the foreseeable future.

The primary goal of any corporate defined benefit retirement fund is to be able to pay all current and future pensions to their members when they fall due (pension liabilities), and to provide annual pension increases in line with the needs of their pensioners – typically linked to inflation. These are the promises a fund makes to its members.  The employer carries the financial burden of a shortfall in assets relative to these promises, and the extent to which that employer is willing (the ‘employer covenant’) and able (the ‘strength of the covenant’) to meet the shortfall, becomes important considerations when considering benefit security.

For this reason, a close matching of assets to liabilities has become increasingly important, particularly in today’s environment of volatile markets and unpredictable returns, where pension plans are exposed to inflation and interest rate risk, which could push them into hard-to-manage deficits.

How would a typical balanced portfolio compare?
According to Johan Kriek, Head: Liability Driven Investments, a typical balanced portfolio as an investment strategy would be expected to provide adequate returns over the longer term to meet these pension promises.  However it does not guarantee a fund’s ability to meet the future expectations of its pensioners. This is because the focus of the balanced fund is primarily on growing assets in line with broad market-linked performance, without directly considering the changes in the valuation of the liability stream. This balanced portfolio approach can prove flawed during unstable and low return markets such as we are currently experiencing, with rising liability costs and falling asset values leading to volatility in funding levels and deficits emerging.

The use of LDI techniques ensures a fund can honour its promises to its pensioners. A lower return environment makes it more difficult to obtain inflation-beating returns from a typical balanced portfolio …

If a fund’s investment portfolio experiences disappointing returns, pensioners generally receive poor or no pension increases. In addition, if there are deficits, the sponsoring company (which carries the risk) will have to make up the deficit in the fund. In addition to this exposing the company to considerable financial risk, accounting regulations require that these pension liabilities be disclosed on the company balance sheet, with any pension benefit costs flowing through the income statement on an annual basis.

For this reason, there is growing interest in reducing the volatility of a pension fund’s funding level, something that an LDI strategy would ensure.

Liability driven investment ensures stable funding levels
At a basic level, says Kriek, LDI is about ensuring that a pension scheme can meet its current and future pension obligations, by matching the interest and inflation rate sensitivity of its assets to the interest and inflation rate sensitivity of its liabilities. Focussing on DB pensioner liabilities, the relative stability in mortality rates allows actuaries to forecast a stable series of payments that would need to be made to satisfy any pension liabilities.  These ‘cashflow profiles’ typically stretch over a number of years into the future (30 years plus) and their current value is incredibly sensitive to changes in the level of interest rates.

Choosing investments that react to interest and inflation rate changes in an equivalent manner is the essence of liability-driven investment strategies.   Importantly, the success of these strategies is not based on whether the return on the assets beats a performance target or a benchmark, but rather whether it keeps pace with the changing value of its liabilities.

In today’s unsettled market environment, LDI is able to remove inflation and interest-rate risk and increase pensioner benefit security 

Transparency, better risk management
A properly implemented LDI strategy should provide trustees with a fully transparent picture of the funding level and its sensitivity to changes in interest rates, the performance of assets versus liabilities, and the potential to lock in gains to offset these liabilities. This level of transparency and information empowers trustees to more effectively manage the overall fund and, most importantly, increases the probability of meeting ongoing pension obligations.

LDI strategies
A typical LDI strategy would begin by understanding the key drivers of a DB fund’s liabilities, its benefits increase policy, funding level and risk appetite. Using this data, a customized solution tailored to the client’s specific risk profile would then be designed.

As a start, interest rate and inflation risks are removed by investing in instruments that match the sensitivity of the pension fund’s liabilities to interest and inflation rate changes. As the liability values rise and fall, the invested assets will keep pace and will therefore keep the funding level stable. One such strategy is to invest in inflation-linked bonds (ILB’s) that will change by the same rand amount as the liabilities in response to interest rate fluctuations.  While all the interest and inflation rate risk is removed, any potential for outperformance of the liability is also removed.

A more common LDI strategy involves removing the interest rate and inflation risks through derivative instruments. As such, the extent to which the performance of the return generating portfolio differs from cash will feed through into funding level changes.  For this reason it is most common to use a portfolio of short term credit instruments linked to cash rates as the return enhancing strategy, as the funding level stability is maintained.

Conclusion
Given its focus on both assets and liabilities, LDI is an essential tool in the trustees’ investment tookit. Importantly, it helps pension funds meet the pension promises made to its pensioners. While the modern concept of liability-driven investment may seem unfamiliar when compared to more traditional asset management, trustees should remember that a properly executed LDI strategy will play a significant role in enabling a fund to manage its risks better, more confidently meet its long-term goals and, ultimately therefore, keep its promises to its pensioners.