Trustees of Cancer Research UK’s defined benefit pension fund have put in place a new liability-driven investment allocation, minimising funding volatility following the EU referendum.
Many schemes are expected to continue hedging their liabilities following the UK’s decision to leave the EU, despite yields rising. Over 2015, the total notional value of liabilities hedged by LDI strategies continued to increase to £741bn from £658bn – a rise of 13 per cent according to KPMG’s 2016 LDI survey. Market uncertainty means that the justification for hedging is stronger than ever, says BMO Global Asset Management’s 2017 LDI Bulletin.
Last year, trustees of the £606.6m Cancer Research UK Pension Scheme committed £122m to a new liability-driven investment strategy.
The allocation to LDI meant that the scheme experienced significantly lower funding level volatility following the EU referendum, when gilt yields fell
Graham Parrott, Cancer Research UK Pension Scheme
Graham Parrott, trustee chair, said that, together with the charity’s senior management, the trustees made plans to reduce risk during 2015-16.
Consequently, “in early 2016 an allocation was made to an LDI strategy in order to increase the hedge against movement in interest rate and inflation, thus leading to a closer match between assets and liabilities”, said Parrott.
He said the trustees had carefully considered the complexities inherent in liability investment strategies before making the decision.
He also said: “The allocation to LDI meant that the scheme experienced significantly lower funding level volatility following the EU referendum, when gilt yields fell.”
The scheme’s trustees “are considering further measures that can be taken to manage the different risks posed by the scheme”, added Parrott.
LDI enables returns focus
Sophia Heathcoat, investment consultant at Barnett Waddingham, noted that Brexit and “the subsequent quantitative easing programme implemented by the Bank of England during a period of reduced market liquidity…resulted in long-dated real gilt yields hitting lows of around -1.9 per cent in early October last year.”
She explained that the average scheme would have seen the value of their liabilities increase by about a fifth over this time.
“For a scheme that had already allocated to LDI before the referendum result, their funding level would have been protected – at least to the amount at which they are using LDI.”
Since then, nominal yields have rebounded to pre-referendum levels, but increases in inflation expectations have dampened the impact on real yields, noted Heathcoat.
“The key is that using LDI can reduce funding level volatility so that trustees can focus on how to allocate growth assets to generate returns to plug the deficit rather than constantly trying to keep pace with a moving target.”
Don’t be a forced seller
When it comes to combining LDI with cash flow needs, John Walbaum, head of investment consultancy at Hymans Robertson, said: “If we assume a scheme has a deficit, the aim is to use the growth assets to fill the funding gap, and the LDI portfolio to protect against interest rates and inflation making the liabilities bigger.”
In that scenario, it is important a scheme does not become a forced seller of growth assets at a bad time in the markets, he highlighted.
“As schemes become more and more cash flow negative, it is crucial that they consider the third dimension of income generation,” Walbaum said.
“The balance can be achieved by investing more of the portfolio in assets which generate contractual cash flows,” he explained, which can be bond assets that throw off coupons or interest plus a redemption payment at maturity, “provided they can avoid default”.
Is liability-driven investment facing a backlash?
The prospect of hefty US fiscal stimulus has triggered talk of global reflation. The subsequent jump in government bond yields globally has prompted analysts to lift interest rate forecasts. But we are still in a structurally low interest rate environment.
It's all about protection
Lucy Barron, LDI solutions manager at Axa Investment Managers, said that given the huge demand from unhedged pension schemes compared with the small amount of supply in the index-linked gilt market, she expects real yields to stay at low levels and negative for the foreseeable future.
With this in mind, she said, it would make sense for schemes to phase into LDI.
“When they are implementing this sort of strategy it is about protecting against further interest rate or inflation moves rather than trying to call the market,” she said.
