Trustees of Thames Water’s two defined benefit pension schemes have been focusing on risk reduction over the past year, introducing a new liability-driven portfolio for both funds.
An increased focus on risk management over the past few years has contributed to the rising popularity of LDI strategies.
A recent survey by BMO Asset Management found that inflation hedging increased to £25.8bn from £23.2bn during the third quarter of this year, making it the second most active since the survey started in 2009.
The increase in popularity of LDI will continue but at a gradual pace as schemes look to take tactical opportunities to reduce risk
Rod Goodyer, Barnett Waddingham
Between 2015 and 2016, the £1.1bn Thames Water Pension Scheme also added a new £571.8m LDI portfolio to its asset allocation.
During the same time period, its £753.2m sister fund, the Thames Water Mirror Image Pension Scheme, invested £488m into the same type of strategy.
The company’s latest annual report states: “The trustees have taken a number of steps to control the level of investment risk within the schemes over the last year.”
It explained that this included decreasing the schemes’ exposure to higher risk assets and increasing the level of protection against adverse movements in interest rates. Prior to the new LDI exposure, both schemes had allocations to fixed interest and index-linked government bonds.
Key considerations
“Most schemes will have an LDI strategy of some sort – at the simplest end this is a holding in long-dated gilts,” said Rod Goodyer, partner at consultancy Barnett Waddingham. “LDI is the best tool available for many schemes looking to manage the volatility of contributions and funding levels.”
When deciding whether to use leveraged LDI funds, a scheme needs to think about how much interest or inflation rate risk they want to have, and whether it is appropriate to the covenant, he explained.
Goodyer added that this needs to be considered alongside the governance impact of adding a leveraged LDI strategy, because they involve a higher level of governance than conventional bond strategies.
A scheme will also have to decide whether its view on the timing and direction of gilt yields or inflation differs from the market.
Goodyer said an increased long-term focus on achieving buyout has made pension funds think more about how to manage their asset risks against the ultimate price of reaching this objective.
“I think the increase in popularity, so to speak, will continue but at a gradual pace as schemes look to take tactical opportunities to reduce risk,” said Goodyer.
Schemes told not to delay hedging
For schemes that have not already hedged liability risk, “it is imperative” that they do so, said Vivek Paul, director, client solutions at asset management company BlackRock.
“It is true that schemes could have achieved more favourable hedging levels had they hedged earlier. But this should not prevent them from delaying hedging now and compounding the mistake,” said Paul.
“Those who have argued for delaying hedging liability risk, and for waiting for yields to rise, have done so for most of the past decade and watched yields grind ever lower,” he observed.
Hedging at a high as schemes lose hope for fast rate rise
Institutional investors in the UK increased inflation hedging by 11 per cent during Q3, according to a survey – a sign that schemes and sponsors have reached the limits of their tolerance for widening deficits.
“The recent increased demand for LDI stems in part from a realisation that predicting the path of future yields is extremely challenging,” said Paul.
He noted that the huge yield movements seen in the third quarter of 2016, post-referendum result, “are a case in point” and “many schemes are scaling back the size of the bet they had made on interest rates”.
Simon Cohen, chief investment officer at Dalriada Trustees, said that ultimately, a lot depends on the strength of the covenant.
“If you’re got a really strong sponsor and you’re prepared and happy to run the risk then you might not want to hedge. But if you’ve got a weak covenant and you want to keep risk down then you should reduce risk, even if [doing so is] quite expensive,” Cohen said.
