Schemes must not leave themselves vulnerable to interest rate risk by ignoring seemingly expensive liability-driven investment strategies, according to panellists at a Pensions Expert event on LDI held last week.
Successful implementation will demand strong employer covenants and longer-term journey plans, experts at the event held in London said.
Putting longer-term gain plans in place gives you road markers, where you know you need to deploy additional LDI exposure
Brian Kilpatrick, Santander Asset Management
LDI is sometimes said to be expensive in a low-yield environment. Angus Scorgie, associate at consultancy Barnett Waddingham, said LDI has been “a little bit oversold” by others in the consultancy business.
“It’s effective, it takes interest rate risk off the table, it takes inflation risk off the table. But it doesn’t solve your problems,” he said.
However, Scorgie also warned schemes avoiding LDI based on the assumption that mean reversion of gilt yields would occur, saying: “History would show that’s probably not the best strategy.”
Interest rate biggest risk
Pension funds are also sometimes ignoring interest rate risk, seen by the panel as the biggest liability within many portfolios.
Some view it merely as a measurement risk, according to Giles Payne, director at professional trustee company HR Trustees.
“There are a lot of people, as schemes go cash flow negative, who are looking at their large gilt portfolios or large LDI portfolios wanting to generate cash,” he said. “The last thing they want to see is a massive drop in the capital value of their assets.”
Journey plans crucial
The panel agreed that schemes with an in-depth understanding of their sponsors’ financial position would be able to avoid interest rate and inflation risk without causing the sponsor severe difficulties.
“The ideal scenario is where as a trustee or a sponsor you’ve got a long-term driven plan,” said Brian Kilpatrick, head of portfolio strategy at Santander Asset Management.
Paying attention to funding levels, targets and expected investment returns when assessing liabilities were highlighted as crucial to planning LDI strategy.
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“Putting those longer-term gain plans in place […] gives you road markers along that journey plan, where you know you need to deploy additional LDI exposure if what’s left as a capital value will not make the deficit good under reasonable growth expectations,” said Kilpatrick.
He added: “It gives the company an element of certainty over the cash contributions and it gives the trustee more comfort over the cash that they’ll see in the longer term.”
He said that schemes’ failure to plan in this way could explain their current reluctance to introduce LDI strategies.
Small funds still vulnerable
Smaller schemes in particular are leaving themselves open to interest and inflation risks, according to Huw Evans, trustee at professional trustee company Bestrustees.
“When interest and inflation hedging is discussed, it tends to be starting from zero and deciding how much to do,” he said.
“Perhaps a more rational approach would be to start from hedging all of inflation or interest and then see how much you can actually afford to remain exposed.”
