Small schemes making most of accessible LDI solutions

An increasing number of defined benefit pension schemes have been moving to LDI over the years as they mature.

The new money going in is going into smaller mandates

Simeon Willis, XPS Pensions

In 2017 the total notional value of liabilities hedged by LDI strategies continued to rise, increasing to £965bn from £904bn, an XPS Pensions LDI survey found.

Given the minimal movement in yields between year ends, the majority of this increase can be attributed to new LDI mandates, the report said.

The research found that 2,140 mandates were in place at the end of the year, up from 1,828 at the beginning. Platforms and fiduciary managers accounted for 41 per cent of new mandates.

Approximately 49 per cent of UK liabilities have been hedged using LDI. XPS Pensions estimated the UK private sector had a total DB pension scheme liability of around £1.97tn on a low-dependency gilts + 0.5 per cent basis as at December 2017, based on Pension Protection Fund data.

Demand for pooled 'profile' funds

LDI used to be the preserve of large DB schemes, but over the years a rising number of smaller pension funds have entered the market.

The report highlighted that growth initially driven by medium and large schemes is now “flowing very firmly to smaller schemes”.

Sixty-six per cent of pooled LDI investors were using ‘profile’ funds in 2017, up from 61 per cent in 2016.

The report noted that the earliest pooled funds followed a ‘bucketed’ approach, allowing schemes to replicate the timing of their cashflows by combining funds with different maturities.

The standard scheme ‘profile’ approach, however, was developed out of a desire for simplicity. It aims to match the liability profile of a typical pension scheme, often with variants catering for pensioners and non-pensioners.

Some providers have moved their bucketed fund ranges altogether, amid an increasing demand for profile funds.

Simeon Willis, chief investment officer at XPS Pensions, said the year under review was “unusual compared to a number of the years we’ve seen, because there wasn’t any growth that came through from the appreciation of LDI funds”.

This is “because the market’s been relatively flat over the year, so all of that £61bn is new money that’s flowed in”, he noted.

Mandates have increased due to the continued adoption of LDI by smaller schemes. “I think it’s directly connected to the ease at which trustees can now access LDI through platforms [and] through simple pooled products,” Willis said.

Pooled LDI represented 11 per cent of the overall LDI market but accounted for a 87 per cent of 2017’s new mandates as more small and medium-sized schemes began to hedge, according to the report.

Scope for future growth

The size of mandates is also changing. At the start of 2017 the average mandate was £495m, but the average value of liabilities hedged across new mandates during the year was £195m.

“The new money going in is going into smaller mandates,” Willis said, adding that, in terms of the percentage of UK liabilities hedged, there is still scope for substantial growth in the future.

Russell Chapman, a partner in the investment practice at Hymans Robertson, said: “We’re seeing a high level of concentration in terms of hedging across most pension schemes.”

Profile funds are often seen as a convenient way to hedge, because they “aim to package a hedge in a neat solution” so the scheme can buy one or two funds rather than having to put together lots of different components, Chapman said.

In addition to simple pooled LDI funds, there has also been “a trend for some of the big scheme solutions to come through to smaller funds” through platforms, and even segregated mandates for smaller schemes are now possible.

Triggers or time-based approach?

Chapman said a lot of schemes that had resisted hedging for a long time, “seem to have changed their view” as they have got better funded, or concluded that the risk of not hedging is no longer worth taking.

Liability matching is not limited to LDI. As schemes are getting better funded they might have more opportunities to use other bond assets, which can “give them the access to better returns rather than just thinking about a gilt portfolio”, Chapman noted.

Simon Cohen, head of investment at consultancy Spence & Partners, agreed that a rising number of small to medium-sized schemes have been hedging their liability risk over the past few years, and that this is set to continue.

“I think more and more schemes are going to be implementing LDI,” Cohen said.

“Quite a few schemes probably had triggers in place where they were waiting for yields to rise, and they haven’t,” he said.

Cohen noted that “schemes have adopted more of a time-based approach now”, rather than having trigger points based on yield levels.