Is liability-driven investment facing a backlash?

What are the implications for pension schemes that have already adopted a liability-driven investment strategy or are thinking of doing so?

We do not expect a backlash against LDI strategies that involve hedging interest rate and inflation risks in this environment. Indeed, we expect schemes to keep derisking as funding levels improve and the potential for higher rates presents opportunities to extend such liability hedging programmes.

LDI schemes will expand beyond liability hedging and provide new ways to optimise returns relative to cash flows.

Rising yields? For real?

All schemes that have implemented LDI strategies would have had to consider the possibility that yields could rise, and that they faced the risk of buying expensive assets just before they become cheaper. 

If there is to be an LDI backlash, it seems unlikely to be led by those who have already wrestled with this dynamic, and who have seen their decision to pursue LDI vindicated

Nearly all schemes that decided to implement LDI despite this risk have to date been rewarded, as gilt yields have plunged ever lower until bottoming out at record lows in August. 

If there is to be an LDI backlash, it seems unlikely to be led by those who have already wrestled with this dynamic, and who have seen their decision to pursue LDI vindicated.

What about schemes yet to commit to LDI? They would have seen, for instance, that in Q4 2016, rising break-even inflation pushed nominal 10-year gilt yields about 50 basis points higher.

Yet most UK schemes have mainly inflation-linked liabilities – and therefore ultimately care more about real yields (or index-linked gilt yields). 

For all the recent talk of sharply higher yields, in 2016 UK real rates fell around 100 basis points and remain significantly below pre-Brexit levels. Looking ahead, long-term structural forces will keep exerting downward pressure on real yields. 

Ageing populations and a debt overhang limit growth prospects, while substantial pension and insurer demand for long-term government debt has created a persistent supply/demand imbalance. 

As pension funds mature, the cost of making the wrong decision becomes ever greater. Many schemes should be hedging more. Continued pension derisking should push more schemes into UK LDI strategies in 2017 – despite the risk of rising rates.

Trustees who have ignored LDI thus far now have evidence of just how low yields can go and will be keen to avoid repeating past mistakes. 

Many pension schemes have now implemented strategies to derisk automatically, selling equities and buying bonds when yields rise. Thus, more assets could flow into long-dated government bonds and interest-rate swaps, even in a rising rate environment.

More than liability hedging

Besides derisking through liability hedging, pension schemes with an LDI strategy can use these existing assets to accomplish other holistic plan objectives. 

For example, capital in an LDI portfolio can be used for adding synthetic exposure to equity markets, hedging foreign exchange risk or investing in synthetic corporate bonds to better match benefit payments.

LDI can also incorporate the cash flows from secure income investments and generate outperformance relative to liabilities through actively managed mandates.

These are examples of how LDI strategies have become more central to portfolio objectives than ever before. Such benefits do not disappear as rates trend higher.

Many pension schemes still need to hedge more to have balanced investment strategies. They will have plans in place to act if higher yields create market opportunities to derisk.

The prospect of a gradually rising rate environment does not diminish the growing importance for flexible LDI strategies to help achieve the return goals for UK pension schemes.

Vivek Paul is director of client solutions at BlackRock