How can LDI be combined with cash flow delivery?

Jonathan Crowther: We still need to move the deficits, and then we have to make sure that we pay pensions, otherwise we are going to be selling growth assets at inopportune times. Plan how you are going to deliver those cash flows so that you are never a forced seller, or make sure you have enough liquidity vehicles that you can repo out collateral and get cash in earlier than the maturing bond.

Mark Foster: It’s important to think about whether assets have liability-aware characteristics, giving the cash flow when you need it. The inflation linkage is also good. The diversification benefits are there, as long as you can take the liquidity premium.

There is the option of creating leverage somewhere else in the portfolio to generate the cash or collateral

Alen Ong, Hymans Robertson

David Felder: Those liquidity premiums are immensely valuable when you have a real gilt yield basis of –1.5 per cent. So many funds have gone into ground rents, high listed value property, and infrastructure in various guises.

Foster: Being really efficient with any underlying cash or collateral becomes important as well. You have to post margin to a clearing house; being able to use that collateral to service both an absolute return engine and the liability-driven investment overlay has big advantages.

Pensions Expert: Should investors be wary of anything with these strategies?

Simon Cohen: If we get yield increases, there are going to be collateral issues. Schemes are used to worrying what to do with all this cash; it might actually be ‘Where are we going to get cash from and what are we going to use to support the collateral?’

Felder: They need to have a formal liquidity policy.

Alen Ong: There is the option of creating leverage somewhere else in the portfolio to generate the cash or collateral. If you had a combination of leveraged and unleveraged pooled funds then you can lever up the unleveraged funds. For the bigger schemes that have segregated mandates, they can lever up their equity portfolios, turning them synthetic, for example. They could also replace corporate bonds with credit default swaps.

If you are dissatisfied with the performance of the growth asset driver you might be more prepared to put up with it because of the cost of coming out of that and the LDI

Sophia Heathcoat, Barnett Waddingham

Sophia Heathcoat: It comes back to making sure that the trustees have plans set in place so that you’re following a pre-agreed solution rather than letting panic come into play and delaying response, which is then going to result in those forced sales.

Felder: Larger schemes have the governance and the advisory resources to manage this. Small and mid-sized schemes less so. That is why products that package return-seeking, LDI and also give you maximum collateral efficiency, are going to be more in demand.

Heathcoat: If you ask the same manager to manage your growth assets and your LDI you are taking a lot of manager risk on there. It is just an alternative to fiduciary management, you could argue.

Crowther: I think the advantage of doing it in a single pooled fund environment is that you do not have the settlement issues that you have when you have separate vehicles. You can move assets from one to the other the same day, instead of a three to five day settlement period, which in a rapidly rising rate environment is less capital-efficient.

Foster: It depends on design, but I don’t think you need to consider them as fiduciary management. It is clear there are big benefits in a pooled fund of having the two together in terms of the additional returns. Manager selection is crucial; they need to have a proven track record on both elements of the portfolio.

Insurers, who have very similar liabilities and similar objectives, have been at this for much longer

Jonathan Crowther, Axa IM

Cohen: You could get passive exposure if you were concerned about the manager risk. That is a bit more difficult with diversified grwoth funds.

Heathcoat: It strikes me that if you are dissatisfied with the performance of the growth asset driver you might be more prepared to put up with it because of the cost of coming out of that and the LDI. It makes the assets more sticky for the fund manager. If you treat the separate products differently you lose the collateral efficiency, but it makes you much more nimble, as a trustee board, to react if you have concerns over the investment manager.

Felder: It is a classic trade-off. In a zero interest rate environment, holding collateral is very expensive. Having an underperforming growth submanager or LDI submanager is also expensive, and it is just weighing that balance.

Crowther: I think as funding levels improve and hedge ratios grow, naturally you are going to have much less of a reliance on growth assets.

Felder: Once you have reached that 95 per cent funding ratio and 95 per cent hedge ratio, you need to decide what you actually want to do with that LDI. Is it just there as a purely passive hedge, so you recoup on your swaps when indicated, and adjust the hedge around the margin, or do you use it as a very mild source of alpha?

Pensions Expert: Is there a crowding risk with the esoteric assets that we might see in cash flow strategies?

Crowther: I think they have already bumped up against it. The insurers have been at this for much longer. They will definitely bid up those assets. I guess it is at what level you think it is reasonable as an investor actually investing in those particular assets.

Cohen: There are regulatory restrictions on what insurers can invest in, so there might be areas where that does not happen.

Crowther: Solvency II has changed the rules for insurers, they used to invest in a lot of global credit, and that is a lot less attractive to them now. So there are opportunities for pension schemes there. That introduces a series of risks, but they are similar to LDI risks.

Foster: You lose the link to UK interest rates, but you can overcome that. We have seen global credit being used to help build a diversified growth portfolio.

Felder: In the growth portfolio you would typically hedge out the currency aspect and you might delta hedge the interest rate aspect of the global bond exposure.

Heathcoat: Why would you not do global, given the comparative size of the bond universes?

Crowther: It is possible to run global credit portfolios alongside LDI portfolios. In the pooled fund space there is nothing that I am aware of at the moment. But where schemes are taking more of a segregated or bespoke approach, the foreign exchange and the long interest rate risk are entirely possible to manage.