LDI – A Great Year for many Schemes
13th December, 2022
On 18 April 1930, the BBC news announcer came on the wireless with a simple announcement “today, there is no news” before some relaxing music played for the rest of the news segment. It seem unlikely that we will ever get a day like that again .
Today, we face news which is fast paced and skewed to the doom and gloom. 2022 has been another proverbial year for this; from the war in Ukraine, three Prime Minister’s, to the cost-of-living crisis to the disastrous September mini-budget and subsequent LDI crisis. It has been a difficult year. Yet, despite all this, I still prefer to focus on the good. To seek out the positives, appreciate what has gone well and think about what upside there could be in the future.
After all, 2022 has been an excellent year for many DB pension schemes. The upward shift in the yield curve and the accompanying fall in a scheme’s liabilities (on the assumption they were not fully hedged) has benefited many schemes in terms of their funding positions. The extent of funding level improvements will have depended on how the scheme’s assets have moved but, as few schemes have been fully hedged, most should have seen improvements. As such, many trustees now have a fabulous problem on their hands of being in a stronger position than anticipated. They will need to revisit their strategy –discuss what are they trying to achieve, by when and how.
What Are You Trying to Achieve?
Working with their sponsors, trustees must be clear what they are aiming to achieve with their scheme:
Buy-Out: A common aim of schemes it to discharge the Scheme’s liabilities, and ongoing costs, from the Sponsor and move them to an insurance company. This is popular as many sponsors (and trustees) have grappled for years with complexities of the defined benefit (DB) world and evolving regulatory needs which, especially for smaller schemes, are a time consuming and expensive endeavour for sponsors. However, achieving buyout isn’t simply about having sufficient assets in place; you need to do a lot of other proprietary work around the data quality, benefit specification and discretion documents, for example. You may also want to be clear why such a risk transfer is indeed in the interests of all stakeholders. If buyout is something you’re looking to do, is there the relevant experience on your trustee board to help with the complex processes involved?
Self-Sufficiency: Some trustee boards are keen to run the scheme Scheme for the long term, but in a way that no longer requires additional contributions from the Sponsor with a significant buffer built into the assets held. Sponsors may prefer this option over paying more for expensive insurance premiums. Moreover, as more funding levels have improved, the insurance market capacity is likely to be constrained in meeting the increased demands so pricing might adjusted.
Master Trust: There are also master trust options where particularly small schemes can join to benefit from the pooling of assets. There are a range of providers who take different approaches to pooling assets offering their own individual advantages and disadvantages.
Regardless of the objective, schemes are now likely closer to their aim. It’s time for trustees and sponsors to step back and consider all options available.
How do you see your journey plan developing?
There are two basic ways a scheme will move towards their aim: sponsor contributions and investment strategy. If sponsors currently have the ability to accelerate contributions, now is a great time to make them as they will secure more liabilities when yields are significantly high er than recent years. At the same time, many sponsors are facing the strains of stubbornly high inflation, higher debt and payroll payments and a recessionary environment looming. It’s worth trustees discussing this opportunity with sponsors but appreciating the pressures their businesses may be under.
Investment strategy, on the other hand, is something that all trustees can and should revisit with the guidance of their investment consultant. We are in a fundamentally different investment environment than when your scheme’s strategy was likely set. Even compared to the beginning of year we are now in an environment with higher gilt yields, higher credit spreads, higher inflation and many asset classes have re-rated pricing. Moreover, for schemes with significantly improved funding levels they are likely several years ahead of their intended journey plan. The investment risk and return profile of the scheme should be revisited alongside a consideration of the sponsor covenant. In other words, the approach should be one of integrated risk management.
Investment Strategy Review
A strategy review should be focused on the liabilities and how your assets can best be invested to meet the needs of your scheme. However, when refreshing your strategy, it is also the perfect time to revisit Environmental, Social and Governance issues. This is a quickly evolving environment and there are now more opportunities for even low risk investment strategies to maximise their ESG credentials.
If your scheme’s funding level has improved, now may be a good time to start considering in “locking in” your funding level gains, reducing growth assets and investing more in matching assets. LDI may play a part in this, recent headlines shouldn’t stop you considering this option. Rather, the importance here is to ensure strong governance structures are in place and the trustees have experience of fully understanding the risks involved. If you are appointing an LDI manager, or investing more assets with them, there will be a few things to consider:
- LDI Manager performance
As with all manager appointments, manager due diligence is required. The recent market volatility has shone a light on the quality of LDI managers risk management processes and client communication.
- Hedge Ratio
What level to hedge is a significant discussion point. This should depend on funding level, broader asset allocation and sponsor covenant. 100% may not be the “lowest risk” position to take.
- Leverage levels
Trustees must be aware of the risks associated with excessive leverage in their portfolio. As a rule of thumb, the lower funded you are, the product’s leverage level needs more scrutiny.
- Liquidity and Collateral Waterfall arrangements
If yields begin to move upwards again – does the scheme have sufficient liquid assets available to meet future collateral calls? Be clear what you would do if there was a cash call.
- Alternatives to LDI portfolios
If there is hesitation to utilise LDI portfolios, a more approximate hedge may be achieved using a basket of bonds. This takes away any future collateral calls but will be a more approximate hedge of your liabilities and may not cover your interest rate or inflation risks appropriately..
Outside of your matching assets, lower leverage that’ll be used in LDI portfolios also equates to needing more assets for your hedge. This means your growth portfolio will need to “work harder” to meet your return objectives. As with all things with investment, you have a trade off between risk and return that needs to be carefully considered.
We can get days where we focus on the good in the world. 2022 has been a great year for many schemes, but much work needs to now be done to ensure they benefit, over the long term, from the gains they’ve seen.