Cover story – LDI
This is not a good time to be promoting liability-driven invest- ment (LDI). In the current climate, an LDI pitch to a trustee board of a UK pension fund might go down as well as selling asset-backed securities in 2008 or tickets for a cruise at the height of the Covid pandemic.
The strategy has made the headlines since the end of Septem- ber for the wrong reasons. The Bank of England has accused highly leveraged schemes which are invested in derivatives of posing a systemic risk to the UK’s financial sector. Not a good look for a risk management strategy. But there is a paradox here as most of the 85% of defined ben- efit (DB) schemes pursuing an LDI strategy are determined to continue doing so, even at a considerable cost, judging by the schemes portfolio institutional spoke to. This raises the ques- tion: what will the future of LDI look like?
A roaring success To understand the reticence to discard LDI, it is worth taking a look at why the strategy was first introduced. In the 1990s, changes to British accounting standards meant that pension
scheme liabilities became part of corporate balance sheets. At the time, most final salary schemes were open and pension scheme liabilities weighed heavily upon corporate accounts. The joke in reference to British Airways of a pension scheme with an airline as a side business is said to date back to that period. The change in accounting rules accelerated the closure of open DB schemes and led to a shift in their portfolios from equities to fixed income. By the turn of the millennium, DB schemes were still predom- inantly invested in equities, which accounted for 75% of the average portfolio. But a year later, the Boots Pension Scheme shocked the industry by converting its entire portfolio into high-quality long-dated gilts. Fast forward 20 years and more than 80% of DB schemes have implemented LDI in some shape or form. But through- out the past 15 years, interest rates were at historic lows, so while bonds offered predictable returns, these returns were predictably poor.
That drove schemes increasingly into using leverage to enhance returns. As of 2019, almost half of final salary schemes had increased their leverage while the combined notional prin- cipal of leveraged investments stood at £498.5bn, according to The Pension Regulator.
There is a world of a difference between LDI and leveraged LDI. The problems we are seeing now all have to do with leveraged LDI. But it’s important not to throw the baby out with the bath water.
John Ralfe, consultant
Schemes also increasingly used derivatives to offset swings in interest rate and inflation risks, with swaps the weapon of choice in that they were held by more than 60% of schemes in 2019.
While the regulator says it is keen not to advocate any invest- ment strategy, it has left itself open to allegations that it has at the very least approved, if not encouraged, the mushrooming of increasingly complex LDI strategies.
A case in point is the DB funding code consultation which closed in October. The draft proposals include a requirement of “low dependency” for DB schemes, which would require them to replace growth-oriented portfolios with fixed income assets, according to Charles Cowling, chief actuary at Mercer. Those who follow LDI strategies argue that it has stood them in good stead for most of that period. Ian McKinlay, who spent six years as chief investment officer of the £40bn Lloyds Bank Pension Schemes, is one of them. “If you think about the severe market destruction we’ve gone through – the global financial crisis, the Brexit shock, the Covid shock and one or two other shocks along the way – LDI did well because it pro- tected pension balance sheets and shielded the corporates from the shock of having to put more money in. “To me, LDI strategies are a roaring success,” he adds. “You can’t blame the current shock on LDI.” But he does, however, acknowledge that excessive leverage, especially for small schemes, who were less able to respond to a rapidly changing market, has been a problem.
20 | portfolio institutional | November 2022 | Issue 118
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