What changes are needed in LDI strategies?

Pensions Expert: Where do you think rates will go over the next year?

Jonathan Crowther: I think long-end real rates will stay at or around these levels. We will probably get some volatility along the way as Article 50 is announced. We are definitely staying negative for the next 12 months, maybe coming back to -120/130 basis points, because I think nominal rates are going to rise across the globe.

Mark Foster: There is so much uncertainty still – not long ago the greater focus was on deflation. Globally there could be an upside risk, particularly on the inflation side, but then the UK has its own unique drivers.

Inflation hedging is still a lot more expensive than interest rate hedging because the price you are paying for an inflation hedge is way above actual

David Felder, Law Debenture Trustees

Simon Cohen: Is there not a supply/demand imbalance structurally, such that even if nominal rates do go up, pension schemes with triggers are going to just start buying it, and it will push it back down again?

Crowther: That is true. But if you look at something like inflation, which is really the driver of real yields, it is quite high relative to the period that liability-driven investing has been in place. I think there is a limit to how far long-end inflation will go.

David Felder: Many schemes have already done more inflation hedging than interest rate hedging; the common view was that inflation was reasonably priced and interest rates were expensive and too low.

Actually, inflation hedging is still a lot more expensive than interest rate hedging because the price you are paying for an inflation hedge is way above actual and has been all the way through, whereas with interest rates you are being paid to move the cash equivalents.

Sophia Heathcoat: It depends on the type of inflation exposure schemes have. If you have schemes that take a delta-hedging approach, then if inflation does start to rise it means you might see people selling off their inflation hedges to allow for that delta adjustment coming through.

Foster: Do clients understand what inflation exposure they actually have? Clearly, long-term inflation expectations are a long way from, say, a 5 per cent cap, but it is a factor that could come into play. Once you hit or move closer to an actual cap, benefits would become more fixed in nature.

Alen Ong: Also schemes have always had a tradition of being invested in real assets. Depending on what kind of inflation we get, a reflationary environment should actually suit some of these real assets.

Pensions Expert: If not inflation, what should schemes focus on?

Cohen: I would like the industry to think harder about the end point, and how LDI links in with buying out liabilities, and better matching the insurance market to minimise the risk. For most it is aspirational at the moment, but more schemes are going to get there.

Felder: I think you have to be quite careful by what you mean by a buyout target. Typically once schemes go cash flow negative, the liability is decaying quite quickly anyway. So what we are really talking about in a typical scheme in 20 years’ time is a buyout of the residual liability.

Crowther: Most schemes will probably end at buyout, but it is whether they get there next year, or in 40–50 years.

I think we will see a number of schemes who would potentially like to go to buyout but just will not get there. So they will be in a stable state where they are relatively well funded, they should be able to meet benefit payments from the resources of the scheme and keep risks minimised through time.

What we might term as 'illiquid assets' are actually not illiquid assets to the scheme; they are providing liquidity when the scheme needs it

Sophia Heathcoat, Barnett Waddingham

Foster: Do small and medium sized schemes have that in mind? It is so far away in terms of funding levels, at the moment, it is probably not something that affects immediate investment decisions, in the sense that it is different from general derisking.

But it is something that needs to be thought about, because it could happen quite quickly through market movements and sizeable company contributions.

Crowther: Whether you are going to buyout or not, I find it difficult to understand why you would not adapt the techniques employed by insurers. It is managing the risks effectively with the minimum use of capital.

Felder: If you want to formally target buyout in the not too distant future, you should have corporate bonds as an integral part of your LDI strategy. At the moment, for most hedged funds, corporate bonds sit somewhere between the growth portfolio and the defensive portfolio.

Foster: You may start to find tranches of benefits being bought out. So you might then get the right assets just for your pensioner population and then look to move those to an insurance company when it is affordable to the scheme.

Ong: The liquidity profile is also important. If a scheme is thinking of buying out in the next few years then they should not be considering long-dated illiquid assets as an investment strategy.

Heathcoat: If you are not intending on reaching buyout in the short term and you are setting yourself a much longer target, then what we might term as illiquid assets are actually not illiquid assets to the scheme; they are providing liquidity when the scheme needs it, and schemes can reap the benefits of that liquidity premium. This is where pension schemes have a real advantage in the search for yield.

Cohen: Do we really understand the liquidity of assets? We could get quite stressed situations in the corporate bond market, where liquidity is not great anyway. Then you have schemes that are invested in these assets and they need cash and they just cannot access it.

Crowther: That is where you can start to think about your cash flow ladder and what is expected to be delivered over the next few years. As long as you hang on to corporate bonds and the issuer does not default, you will collect the cash from them, so it is a case of structuring cash flow delivery from coupons, maturity proceeds, and perhaps more esoteric asset classes or rental income.