Article for Public Service Review on Liability Driven investing (LDI)

by Dr. Ros Altmann

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Approaches to pension fund investing have changed in recent years.  As deficits have opened up, replacing what were previously thought to be comfortable surpluses, trustees have realized that traditional investment thinking may not have served them well.  The modern approach revolves around what is typically called  ‘liability driven investing” (LDI), but what does this really  mean?

LDI is often confused with the idea of switching from equities into bonds.  That is, in my view, not what it means at all.  LDI is all about the concept of ‘risk’, and how to best plan to pay the pension liabilities.

In the past, pension fund managers and trustees were aiming to achieve long-term returns, within ‘acceptable’ risk parameters.  But this concept of risk was not really very well-understood and was usually confused with ‘volatility’. However, the real risk in a pension fund is whether or not the investments will deliver sufficient returns to allow members to receive their promised pensions.

Until recently, trustees simply seem to have assumed that ‘superior’ long-term equity returns would allow them to meet their scheme’s liabilities.  Exceptionally strong equity markets in the 1980’s and 1990’s lulled people into a false sense of security.  Equity returns were expected to stay high and trustees seemed unconcerned that ‘expected’ returns might not actually materialise, or that liabilities might rise more than predicted.

In essence, traditional investment thinking was to ‘manage returns’ and ‘take risk’, almost welcoming risk-taking – primarily in equities.  There was no protection against sharp falls in equities, but this was considered relatively unimportant for long-term investors, because they believed equity markets would always recover, so trustees should not worry about short term setbacks.

The real risks faced by pension funds were not specifically addressed i.e. the risk that they would not have sufficient money to pay the pensions in future.  In fact, equity investments carry two kinds of risk, but investors can only expect to be rewarded for one of them.  The ‘risk premium’ for volatility and company credit should be rewarded eventually (if the right companies are invested in), but the second risk is that equity returns may not actually keep up with pension liabilities and there is no economic rationale that says equities should deliver sufficient returns to match increases in salary inflation and mortality.

Trustees are now focusing more explicitly on managing risk and meeting liabilities.  That is the essence of LDI.  It is about managing both investment returns and risks. But this does not mean switching to bonds to ‘reduce risk’, on the premise that pension liabilities are like bonds.  Pension liabilities may be ‘bond-like’, but they are not bonds.  They entail risks which cannot be matched by fixed income investments, such as duration, salary inflation, mortality, credit and limited price inflation. Furthermore schemes in deficit need to outperform the liabilities, not just match them.

LDI approaches aim to help overcome some of the muddled thinking on risk.  Switching to bonds can reduce interest rate and inflation risk somewhat, but only at the cost of much lower expected returns.  In fact, switching to bonds could make pension funding worse, not better.  LDI still requires finding extra sources of expected returns, but perhaps with greater diversification, more emphasis on absolute returns and attention to downside protection relative to liabilities.

Focussing on managing both returns and risks is a vital part of LDI.  This represents huge new challenges for trustees.  For example, swaps overlays are better than bonds for insuring against unexpected movements in interest rates and inflation, while freeing capital to invest in a diversified portfolio of return-seeking assets which are not highly correlated with each other.  With some downside protected, alternative assets and absolute return focussed funds should be able to provide a more efficient portfolio than relying on just one source of alpha and beta from equities.

Of course, investing in alternative assets as part of an LDI approach requires large amounts of governance time and top investment advisers.  There are also significant practical problems of using swaps overlays or derivatives (administrative, pricing and valuation problems, collateral management).

Nevertheless, modern money management can help trustees manage their assets in a more risk-controlled manner, focussing on actually paying the pensions, which is surely what this should all be about anyway. There are no easy answers, but LDI is here to stay and a proper focus on the liabilities is essential.