Barker Tatham's Steve Barker, PTL's Richard Butcher, Spence's Marian Elliott, Legal & General Investment Management's Laura Brown, Axa Investment Managers' Jonathan Crowther and Redington's Dan Mikulskis discuss developing an LDI programme.
Dan Mikulskis: You have to react to events as they occur. When the early adopters put liability-driven investment programmes in place in 2004 and 2005, it was all around swaps and cash. The swap curve was higher than the gilt curve at that point, so there was a strong case for using swaps.
People did not foresee the fact that those curves were going to move around a lot and then it would become beneficial to have the flexibility to move in and out of gilts and swaps – on both nominal and inflation – at different points in time.
So I do not think you necessarily plan for things to evolve in a particular way, you just want to have the flexibility, and that is one thing we have learned.
Steve Barker: A lot of over-engineering has gone on in LDI. There are three big risks that most pension schemes face: long-term interest rates, inflation expectations and equity market exposures. The interest rate and inflation risks were as big as the equity exposures. Taking 90 per cent of the risk off the table for 10 per cent of the cost and effort is probably the sensible place to go.
Making inroads into that last residual 10 per cent does not really make much of a difference at scheme level.
Some of the solutions I see are not only over-engineered but actually misguided, in that for most schemes the risk they face is that their assets underperform their liabilities as their scheme actuary is calculating them. It does not matter whether you believe that the scheme actuary is calculating them in a sensible way or a completely ridiculous way – it is how the scheme actuary is doing it that matters.
Laura Brown: That comes back to the importance of dialogue between the provider, the consultant and the client, and the transparency around the LDI solution. It is obviously good for nobody if the outcome is not one that is expected by the client because it has not been communicated upfront.
Marian Elliott: That can be a problem for a lot of trustee boards – they get some information from a covenant provider, at a different time of year they get some information from their investment consultant about an investment strategy, and then later an actuary takes a different approach and tells them, ‘Sorry, actually this is the different hole that you have to fill’. Trying to get those lined up can be very difficult for trustees.
The regulator’s latest statement on defined benefit funding is very positive in reinforcing the need to look at all of those three things together, and that will cause advisers very much to have to up their game in terms of presenting some coherent strategy to a trustee board rather than, ‘This is my piece of advice, do with it what you will.’
Richard Butcher: It is interesting. It is not a million miles away from the holistic balance sheet that Europe proposed and that everybody pushed violently back against.
Elliott: That is probably where the difference between a holistic balance sheet and a balanced funding objective comes in. You are actually taking into account what the company needs to do outside of funding the pension scheme and recognising that to have a sustainable scheme in the long term you need a sustainable company supporting it, at least until it gets to such a stage that it is a manageable risk and you have got a very strong expectation of being able to meet the members’ benefits, regardless of what happens to the company.
Brown: I suppose, over time, as pension schemes mature, that emphasis on the company and growth aspect will become less of an issue because the funding position will have improved.
Jonathan Crowther: That depends to a large extent on the strength of the sponsor covenant. If you have no concerns about the strength of the covenant then you can be much more relaxed about your risk management, although for many schemes covenant is an issue – it has to be because there are no guarantees. Over the past five years we have seen some huge organisations disappear that 10 or 20 years ago would have been inconceivable.
Therefore, as covenant is likely to remain a big consideration, even as schemes become better funded over the next 20 years, we will probably see sophistication increase. Remember, we can already see there is limited buyout capacity, so many schemes will not be able to offload the remaining risks, but will be forced to manage these risks, just like an annuity fund. At present, interest rate and inflation risks tend to dominate, and these can be managed through use of gilts, swaps and repos. However, as these risks reduce, many of the second order risks – such as basis risks and close matching of future cash flows – will start to become more important and require use of a wider range of instruments, such as asset swaps and basis swaps.
Butcher: It should be a very dynamic process. Our liabilities are very dynamic, our employer’s covenant is very dynamic, our regulatory environment is very dynamic. Everything can change over a 20-year period.
Elliott: Do we really think that given that there is this capacity problem coming – that we can all see – that there will not be people entering the market to cope with that capacity problem?
Crowther: There will be issues in terms of self-sufficiency and the availability of longevity protection. For example, there is a chance that capital will appear to support the risk on the other side of the longevity transaction, but it is likely to rely upon longevity, or more precisely, the rate of improvement in longevity stabilising.
Barker: There is always going to be a problem with reinsuring longevity. There is a limit to who is going to take that risk on. In my view, you have got to be bonkers to bet against mankind’s ingenuity to prolong our own lifespan.
