How will LDI portfolios withstand current inflation falls and low yields?

Laura Brown: We have seen, surprisingly, an increase in hedging activity over recent years, despite yields being as low as they have. A lot of pension schemes are therefore feeling quite happy that over last year they did okay because they had put in place programmes before further significant falls in real yields unfolded.

However, it is clearly the case that there are still many schemes who have not done as much as they could have done, and for those cases, it has been a more difficult 12 months. We are seeing a big uptake in smaller schemes looking at and implementing liability-driven investment.

Alan Gander: I am never sure if there is a good time to go into LDI. We are looking at it and have almost got to the last hurdle, but we have been talking about it for about 18 months now and when we talk to our advisers they will say, ‘Well, if you did it five years ago, it would have been good. It is not as good now as it was two years ago, but can you afford not to do it?’ For most schemes and trustees, it is a matter of saying, ‘Look, you just have to get into it somehow.’

Mike Roberts: One of the unhelpful things I have seen over the past few years, maybe from consultants and maybe from the investment management world is, ‘Well, we have a view that interest rates will go up in the future,’ so trustees are thinking, ‘Let’s not rush into LDI then’ – but of course it has gone actually the other way. If you are going to move to LDI, then do it, or establish a mechanistic plan as to when to introduce it with defined parameters in this plan.

I am never sure if there is a good time to go into LDI

Alan Gander, AMNT

Mark Versey: Schemes continue to look at doing LDI because they are not immune to interest rate and inflation risk. The interesting thing is that hedging these can be separated as decisions, but which market level is right? Are the market rates fair for inflation, or for interest rates, or both? The levels are not consistent.

You can hedge inflation at 3.2 per cent for 30 years, but to hedge interest rates you currently would lock in interest rates at sub 2 per cent for the same term and these levels are not consistent with each other, ie you will not have 30 years of inflation at 3.2 and 30 years of interest rates at 1.9 per cent. That is a negative real yield of 1.3 per cent and why would a scheme want to lock into that?

Simeon Willis: Why would you not have that?

Versey: You may have negative real yields in the short term, and the market is certainly predicting that, but we think that these rates are wrong in the long term. A negative real yield for 30 years is quite a bizarre scenario for any sort of global economy to live in.

Celene Lee: Just because you observe negative real yields for the entire duration of the real curve does not mean that in reality interest rates can really be negative every year for 30 years. That scenario, admittedly, is quite unlikely, even if you can look at the curve and say that is what the market is telling you.

Versey: Absolutely. So if you are a pension scheme now and you lock your entire liabilities into -1.3 per cent of real yield for 30 years and you have a target to beat your liabilities by, say, 2 per cent a year – ie that is your long-term investment target – you have so far locked in 1.3 per cent of underperformance from your assets. However, what you have done is taken a lot of risk off the table.

Brown: In our experience, generally, clients are not going from being 0 per cent matched to being 100 per cent matched. But they are taking some steps to narrow down the range of outcomes by matching things a bit more and then put a plan in place to increase their matching over time.

Kearns: What schemes need to do is line up all of their risks so that they understand what risks they have and then look at some scenarios and consider whether they can tolerate the outcomes associated with those scenarios. They’re then better placed to determine what asset allocation they need to deal with those scenarios.

Gander: At the moment the big discussion is: do we hedge inflation at, say, 60 per cent, moving from something like 20 per cent at the moment? I think that is a good idea. And with interest rates, do we go the full hog and do 60 per cent on interest rates? No, it is not a good time to hedge interest rates, so therefore should we hold off on that and wait until the 20-year interest rates look better?

Versey: If you want to hedge 60 per cent then that may be the first 15 years of the rate curve and not hedging your long-dated liabilities to interest rates. So that is how you could apply it.

However, if you want to hedge 100 per cent of your risk, we would now say now is not the right time to do that on interest rates, but that is a changed view for us. In November we were still saying, ‘On interest rates, okay to hedge,’ but at these current rates we are now saying, ‘Do not hedge the long end.’

Some of the schemes are actually now waking up to the fact that maybe they do need to hedge

Celene Lee, Buck Consultants at Xerox

Kearns: Just do something. Anyone who hedged a decent amount of risk, even if they did it in an unsophisticated way five or 10 years ago, it probably looks great. It might not have been the optimal hedge, but at least they took some action, and they probably took that action at a time when they thought rates were low.

Lee: A few years ago, when the interest rate curve was extremely steep, the long end of the curve was still around about 4 per cent a number of years after the implementation of quantitative easing. Everyone was expecting interest rates to rise.

So if you were to talk to clients at that time, they would say, ‘Well, actually, I do not really want to hedge,’ especially the ones that had very strong views. So if they do not want to hedge at 4 per cent, you are going to have a hard time convincing them to hedge at 2 per cent. And yet, I actually find the reverse is true. Some of the schemes are actually now waking up to the fact that maybe they do need to hedge and starting to look into setting up a hedging programme.

Willis: Around a quarter of liabilities are hedged, so that means about three-quarters are not hedged. There is often confusion around separating the two decisions: rates and inflation. People seem to think they are two separate decisions, whereas in fact I think they are two different elements of the same decision.

This roundtable was chaired by Pensions Expert reporter Tom Dines