How LDI trigger frameworks could add value for schemes

At the same time, new strategies and products aiming to get value out of a hedge are currently being developed by managers and consultants. Many are asking how efficient trigger frameworks are at safeguarding against liabilities. 

A work in progress 

“Investors need a means of converting the liabilities into an investible benchmark that enables the client and the asset manager to see where value is being added or not,” said Ian Maybury, an independent trustee, during a panel discussion at Pension Expert’s LDI Innovation event last month. 

He stressed that putting a hedge in place “can’t be set-and-forget”, as it is inevitably a function of current market prices. It needs to be adjusted as required by markets to remain effective. 

LDI, more than most other assets, is best tailored to the needs of individual schemes. There is a large variety of instruments out there, which require different levels of expertise and involvement.

The need to choose the right one at the right time has scared off investors in the past. 

“Many clients have remained under-hedged because they have this view that there’ll be a better time to hedge,” said Richard Cooper, head of investment solutions and consulting at asset manager Momentum.

As a result, there has been a move towards building frameworks that will hedge schemes when they want to be hedged. 

Judgment call 

Cooper believes there is a natural connection between the funding level and the amount of risk a fund should take from being under-hedged.

If a scheme has a good funding level, it can spend on building a good hedge at the cost of returns. However, if the funding level is low, then more of the risk budget may be needed to invest in growth assets. 

The decision to put in a trigger framework is quite sophisticated. It is making a judgment call that says: I know better than the market.

But the appropriate transaction to access that added value, through swaptions for instance, is not always in place. 

“If you have a view that’s different from the market, the market will pay you for that view,” Maybury said.

Potentially, investors are leaving a large amount of value on the table when they don’t reap the rewards of putting these triggers in place. 

“If you’re making a judgment against the market, get paid for it,” Maybury added. 

Trigger warning 

Investors should also not lock themselves in, in case the interest rate rises. Cooper pointed out that just crystallising the triggers with swaption strategies may not quite cut it.

“It misses out on the potential to do the hedging if the rate goes above your target level before the swaption runs out,” he said. 

It is possible that pension scheme deficits will unwind naturally thanks to cash contributions or rising interest rates.

Triggers can work against this process by buying gilts automatically, regardless of their price, if a certain trigger point is hit. 

Head of investment strategy at BP Investment Management, Opkar Sara, agreed that using triggers is a more intelligent way of getting to the right hedge ratio, compared with just building the hedge at any price. But he admitted it was a difficult question.

“Once you’ve got your risk limit you really ought to get to the derisking stage that you want as quickly as possible,” he said. “There’s nothing quite as galling as regret risk.”