Has LDI become too expensive?

Rakesh Girdharlal: Often cost of LDI is measured based on how low yields are. A year ago, everyone would have said yields are too low, and today we are sitting at lower yields, so if it was costly last year, it is even more costly this year, and you do not know if it will be even more costly next year.

If you can afford to take the risk that is fine, take it in the right size, but for most pension schemes it should not be a risk they feel they can afford to take.

Giles Payne: That is the key point: you may consider it expensive, but it is a whole lot less expensive than not doing it.

Huw Evans: It is an insurance premium, in effect, so the price is market-driven. So if it costs more this year than it did last year, it is because the risk – your exposure – would be higher.

Barbara Saunders: The difference with it being an insurance premium is quite often with LDI it is a trade-off of risks. So somebody has the equal and opposite risk to you and the cost, therefore, is just a facilitation cost of bringing the two parties together.

Girdharlal: Most people tend to look at cost as thinking it is more the cost of the regret risk; that I am putting a hedge and actually the yields went the other way, as opposed to the cost of actually transacting these instruments. That cost is fairly minimal compared with the overall benefit.

Saunders: If you look at the pound amount you are paying it might seem large, but relative to the risk you are taking away and the amount your liabilities have moved in the time you have been considering whether or not the amount you are paying for LDI is good value or not, then actually LDI is extremely cheap. The numbers are big because the risk is big.

Simeon Willis: I see there being three elements of what could be called cost. The first is management fees, and in general management fees have come down steadily.

Then you have transaction costs, which is when you enter into a swap or gilt derivative. They really spiked in 2009, but they settled down shortly after and I think those costs are at a long-term, normal level now.

The third one is the market level you go in at. I would not really see that as a cost; the direction of the market from there on is either a profit or a loss, but should be offset by whatever happens in your liabilities.

Evans: From a trustee perspective the worry is more around the regret risk; that if you go in now and interest rates rise, your sponsor will turn around and say, ‘I told you so. Why on earth did you hedge when you did?’

Payne: Because if you secure all your interest rates at this level there is an absolute cost to the sponsor.

Willis: That is a cost they are already reflecting in their valuation, so you are just locking in the cost they have already accepted rather than introducing a new cost.

Payne: But by doing that you are effectively locking into your long-term required rate of return for the scheme as well, and that is where sometimes the employer will have problems with it.

Evans: Technically you are right, it is just if interest rates move against you and when they are low it feels as if the risk of regret is much higher. And then, at a later date, it just feels as if you have, in effect, paid a lot for that cover.

Girdharlal: I have heard trustees say that for the past 10 years, and yields have gone one way. Someone who said, ‘I will take that risk off the table’ 10 years ago is looking very healthy today. At some point you are going to have to take this risk off the table.

I think you need to manage regret risk and maybe not hedge all your liabilities at a single point in time. Set a timescale over five years and take the steps to gradually increase your hedge.

Payne: The argument that interest rates have been going down for the past 10–15 years would tend to point to an increased likelihood they will go the other way.

Girdharlal: I can show you the bund in Germany yielding -30 basis points on a five-year maturity.

Willis: Regret risk is a terrible way of making decisions. It is something you should acknowledge and it is perhaps a psychological phenomenon, but it needs to be put to one side because if you have a choice of certainty and uncertainty, the risk lies with the uncertainty, not the certainty.

Payne: I am more worried about the probability issue of, ‘It has been going down for 10–15 years, therefore it will continue to go down.’

Saunders: Well, we have always been talking about that outlying Japan scenario, whereas actually should we think of it as all headed towards being like Japan? Because they are a much older demographic – we are all in ageing populations – they started this 20 years ago and have had very low interest rates for a long time – perhaps we are all moving in that direction.

Payne: I am taking that as a possibility. I would look backwards with care and not project too much forwards. I am not saying we should not hedge.

Girdharlal: No, it should not be based purely on historic numbers, it is also about managing risk. To your point on Japanese yields, if you look at the long end of the sterling curve, so 20 years forward for example, we are trading through the Japanese yield.

Benoît Jacquemont: A way in which I like to explain it to clients, to make them realise the kind of bet they are implicitly taking by deciding not to hedge liabilities is that, basically, they are expressing an economic scenario which is extremely positive, like a consistent growth surprise scenario, where equity will outperform and yield will rise in a very trending way. And it makes them realise that the current investment strategy just acts around a single scenario as opposed to being a bit more diversified and accounting for some downside risk coming from less favourable scenarios.