LDI growth continues across UK schemes

In April 2018, Hymans Robertson argued in a report that pension funds are “approaching peak LDI” – noting that the current pace of rate hedging can only continue for another three years, at most.

Typically, it’s small schemes that are using platforms, and often fiduciary managers, to access a wider range of funds

Simeon Willis, XPS Pensions

Data tracked by MandateWire over 2018 suggest there is little sign of LDI activity slowing down.

The intelligence service recorded around £3.4bn worth of reweightings to LDI allocations, planned reweightings and new mandates.

LDI is now a £1tn market, according to XPS Pensions’ recently published 2019 LDI survey.

The report estimated that the proportion of liabilities hedged with LDI has increased to 54 per cent in 2018 from 49 per cent the year before.

It also found a 12 per cent increase in total mandates, to 2,405 from 2,140.

Simeon Willis, chief investment officer at XPS Pensions, says that a large proportion of the increase in LDI mandates over 2018 is due to platforms and fiduciary managers.

Overall the number of mandates increased by 265, and the biggest single contributor to this was directly accessed pooled funds – with 127 mandates. There was also a substantial net contribution of 118 mandates from platforms and fiduciaries, according to the survey.

There was a 52 per cent increase in the number of mandates accessed via the Mobius Life investment platform, the research showed.

Smaller schemes increase exposure

Earlier this year, Pensions Expert reported that the £86m Caffyns Pension Scheme had appointed a fiduciary manager, leading to a restructuring of its investment portfolio. This included the introduction of a new LDI fund.

“Typically, it’s small schemes that are using platforms, and often fiduciary managers, to access a wider range of funds. So we think it sends a really clear message that smaller schemes are increasingly adopting LDI,” Mr Willis notes.

Around 39.4 per cent of the pension funds logged in 2018 by MandateWire as having awarded mandates, allocated more money to LDI, or revealed plans to do so, related to smaller pension schemes with total assets under £300m.

Source: Mandatewire

Paras Shah, head of LDI at fiduciary manager Cardano, says that with more pooled fund solutions becoming available, “it is pretty much now the bread and butter of even smaller schemes to have a form of LDI” in their investment strategies.

However, there are some small and mid-sized schemes “which may have not done all the hedging that they need to do”, Mr Shah notes.  

He says that as smaller schemes “get more educated… understand what it’s about, the adoption is increasing” when it comes to LDI.

Furthermore, over the past year in particular, Brexit headlines have prompted more trustees to consider derisking, rather than letting the risk run for even longer, notes Mr Shah. He adds that this has resulted in an increased LDI adoption rate.

Gilts trump swap-based approach

The XPS Pensions survey found that 86 per cent of notional liabilities are hedged using gilt-based derivatives instead of swaps.

Pension funds can use gilt-based derivatives, such as gilt futures, gilt repurchase agreements or gilt total return swaps, to hedge liabilities.

Alternatively, they can use swap-based derivatives such as inflation swaps, real rate swaps and interest rate swaps.

The XPS Pensions survey highlights that the latter can provide a closer fit to a pension fund’s cash flows. However, only 14 per cent of notional liabilities hedged using LDIs are implemented through swap-based derivatives.

Mr Shah says that, historically, Cardano has had a lot of clients with swap-based benchmarks or swap-based instruments for liability hedging.

But he notes: “Certainly in the past few years there’s been a big change towards gilt-based hedging.”

One reason for this is that the yield on gilts has generally been more attractive than swaps, Mr Shah explains.

Mr Willis agrees, adding that another reason why gilts are so popular relates to the fact that the majority of pension schemes are funded on a gilts basis.

He explains: “When the value of gilts fluctuates and leads to a change in the value of their liabilities, if you’ve got a hedge in place using a gilts-based derivative, that will move to neutralise that risk.”

If a scheme has a hedge using swaps, there is then a degree of “basis risk” so, “although you’d expect swaps to move in general in the same direction as gilts, sometimes they don’t and there may be some mismatch that you have between your liability movements and your hedge”, Mr Willis notes.

How mature schemes will use LDI

Last year the BBC Pension Scheme reduced its exposure to equity markets in a bid to lock in outperformance with private credit, alternative matching assets and LDI.

Similarly, earlier this year the Shell Contributory Pension Fund announced that, after finding the scheme was 108 per cent funded, it had introduced new allocations to investment-grade and liquid assets, while slashing its return-seeking portfolio exposure.

For many schemes funding levels have improved due to higher contributions and good equity and growth asset performance. Furthermore, many pension funds have matured. 

These types of schemes are likely to move towards a mixture of LDI and yield-based investing strategies, according to Mr Shah.

“As you move into this world of more mature pension schemes, better funding levels, you don’t need your typical strategy of growth… you could arguably move into a lower-risk strategy that is purely fixed income-based where you understand what your exact returns will be in that portfolio,” he says.

This leads to schemes investing more in fixed income-based instruments, such as infrastructure debt and corporate bonds.