Is there still a place for triggers in LDI strategies?

Pensions Expert: Are triggers still a useful tool for schemes starting out on a hedging journey?

Jonathan Crowther: We have to start repairing the hole in some way. Time is my variable now. There are strategies that are based around market events, but I think on the whole it is more about understanding where you are going.

A number of schemes had yield triggers in place for several years, which were never hit, despite revisiting them

Mark Foster, Standard Life Investments

Sophia Heathcoat: It is very much impacted by the size of the scheme. For example, talk of writing payer swaptions to implement trigger strategies and receive premiums is all well and good for a large pension scheme, but for a scheme of up to £500m those ideas become a lot more challenging to implement.

Mark Foster: In pooled funds, until recently there was little ability for a lot of the small to medium-sized schemes to get liability-driven investment protection in place without sacrificing growth. So it was not just regret risk, it was the fact that they would have to give up growth to do it as well.

Pensions Expert: Is accessibility improving at all for the smaller end of the market?

David Felder: Yes, I think there is much greater understanding of how pooled, leveraged LDI funds work now. Schemes are much more aware that you are leveraged anyway if you have an excess of liabilities over assets, and you do need to contain the volatility around that.

Crowther: The leverage point has been misunderstood. LDI techniques are all about transforming risk; it is not so much about levering up in the way that a hedge fund might. It is changing the nature of the risk from something that is very hard to manage – long-dated real interest rate risk – into something that is more akin to a short-dated cash-type return risk.

Simon Cohen: Interestingly, the Financial Conduct Authority’s market study said that it felt that there was competition within LDI and the providers were innovative, which is probably true.

Pensions Expert: Are triggers still of any value?

Felder: Forecasting interest rates has not been a very successful strategy in the last few years, and the market’s capacity to forecast rates probably has not improved.

The best thing a client can do is to look at whatever risk measure they are using, and they will always find that interest rates and inflation dominate those exposures. You just have to build up the hedge over time. They might have some acceleration or deceleration aspects to it, but that is a second order.

Heathcoat: A lot of smaller schemes have an allocation to gilts, usually unleveraged. Just converting that to a leveraged gilt exposure, you are then freeing up assets so that we are not only talking about reducing risk, but we can then potentially enhance the expected returns of the asset portfolio.

Foster: Triggers seem to be less popular now. A number of schemes had yield triggers in place for several years, which were never hit, despite revisiting them. Yield-based triggers combined with time-based triggers or funding level triggers can be more effective.

We want to be very careful about economics-driven forecasts about why interest rates are going to increase. There is a regulatory push to take risk out of the financial system

David Felder, Law Debenture Trustees

Heathcoat: I think you could argue that everyone set triggers in the wrong direction. What if everyone had set triggers on where we just need to get the hedge on because we cannot afford to lose any more?

Maybe trustees should ask, ‘If there is a valuation and the rates are at this level, are we going to give our sponsor a real problem?’

Cohen: This is interesting, because I am experiencing a lot of employers at the moment who suddenly have strong views that interest rates can only go up.

Felder: We should probably ask why the markets previously underestimated the capacity for rates to fall. I think part of the explanation is a supply and demand story, and partly the regulatory aspect.

What you have now is institutional buying by insurance companies, who have very good reasons to hold gilts, and more so corporate bonds.

Pension funds clearly have very strong regulatory pressures to keep the value at risk down. That drives schemes towards fixed income strategies.

Crowther: I think around the late 1990s a series of pieces of legislation pushed schemes to grant benefits that never had been funded for in the first place, like guaranteed pension increases in payment linked to inflation and capped. Also FRS17, IAS 19 – all these pushed us into a much more bond-dominated regime.

Felder: That is why we want to be very careful about economics-driven forecasts about why interest rates are going to increase because of economic factors and new US administrations or Brexit or anything else. At the end of the day, there is a regulatory push to take risk out of the financial system.

Crowther: Everything is being focused on reducing leverage, reducing risk, taking out as much as can be possibly done to try and avoid what happened in 2007-08.

We might see rates nudge up a little bit this year, but in the grand scheme of things, it is deck chairs on the Titanic. We are at -150 [basis points], or at -130 and we want to be at +120; we are not ever going to go back there.

Foster: We have never been massively in favour of triggers because they do not take account of the sponsor’s ability to underwrite the risk that remains on the table until triggers are hit.

A relatively quick change in long-term interest rates and the economic backdrop could leave the sponsor looking significantly weaker with an even bigger deficit. You would need to scrap your triggers and completely rethink your investment strategy.

Cohen: But then you just set up a trigger structure that says that if the covenant changes we look at it.

Felder: The most sophisticated use of triggers actually is by the largest schemes with sophisticated governance resources available who use swaption strategies.

Pensions Expert: Should schemes look to set triggers for drops in interest rates?

Alen Ong: I have not seen those types of triggers being used, but I can see there is an economic logic to doing something like that.

Felder: That is what a swaption strategy delivers. Effectively you are selling some of the upside, which may or may not materialise, in order to ensure that you do have cover if interest rates fall below specified levels.

Heathcoat: Unfortunately it is only available to the largest schemes. And there is also an educational need for trustees to get comfortable with using them, but they are a very useful tool for tail-risk management.