LDI – Feature
Defined benefit (DB) pension schemes are living through a period of rapid change. Stock markets are crashing and inflation is rising, but so are bond yields. This is having a dramatic effect on DB balance sheets. A rise in the discount rate has dramatically reduced the present value of liabilities and, for the first time in years, final salary schemes are sitting on healthy surpluses, despite the value of their assets falling. This should be welcome news for trustees who have struggled with rising liability for almost a decade. By the end of May, the Pension Protection Fund reported that DB schemes had a combined surplus of £261.6bn, which presumably makes it easier for trustees to sleep at night than the £176.3bn deficit they collectively had to manage around the same time two years ago. The cornerstone of liability-driven investing (LDI) is to hedge assets against interest rate rises and infla- tion. But how effective are such strategies when both factors change rapidly at the same time? Is there any point in hedging against a falling discount rate? And is does LDI still have a role to play in DB schemes.
Love it or loathe it
There are few topics as contested in pensions as the merit of focusing on the value of liabilities when managing assets. Advocates argue that it can be effective in reducing the volatility of the dramatic swings in liabilities trustees have to manage. In the- ory, an effective hedge allows a scheme’s assets to match any change in its liabilities. Opponents of such a strategy point to a short-term focus on liabili- ties is taking attention away from a pension scheme’s primary directive of paying member benefits in full and on time.
Other criticisms include using discount rates as an indicator of financial health overstates the value of a scheme’s liabilities and has contributed to the decline of DB schemes during the past two decades, despite improvements in the value of their assets. Critics claim it has led to a misallocation of capital into rela- tively lower yielding fixed income assets, which could have been invested in higher returning markets. Love it or loathe it, LDI has become part of the furni- ture in the DB pensions industry. Indeed, 96% of medium-sized final salary schemes employ such a scheme, while 70% of larger schemes have imple- mented LDI in one form or another, Mercer says. At the start of 2022, a third of DB schemes have
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