What will LDI adoption look like over the next few years?

The reality is that over the past decade, the investment strategies of many UK pension funds did not deliver and some, perhaps unknowingly, took on outsized risks relative to their liabilities in a bid to improve funding positions.

The shape of liabilities is continuously changing due to benefit structure changes, transfers out, mortality changes and buyouts

Over the past 10 years, long-dated interest rates have fallen by around 2.5 per cent (from roughly 4.5 per cent to about 2 per cent), resulting in pension liabilities increasing by around 60 per cent and deficits soaring in value.

Deficits have risen by more than £400bn and almost 1,000 schemes are currently at risk of falling into the Pension Protection Fund, a position that could have been avoided if more funds had adopted liability-driven investment strategies.

Against a backdrop of tightening monetary policy, tariff wars and ongoing geopolitical uncertainty – headlined by Brexit – we have entered into an unpredictable period in markets, and risk management should be high on the agenda for UK schemes and their sponsors.

It is tempting to assume interest rates cannot go any lower and deficits cannot get higher, however, interest rates can go lower as evidenced by Europe and Japan.

The job is not done

It is crucial to remember LDI strategies allow pension schemes to continue investing in return-seeking assets while hedging out their liability risks through the use of leverage.

Given that most pension schemes are still in deficit, the use of LDI strategies is likely to remain high for several years to come.

In addition to managing interest rate and inflation risks, there is also longevity, end-game planning (be it self-sufficiency or buyout), maturing of pension schemes, covenant strength, the deficit and liquidity to consider. LDI has a role to play in managing all of these risks.

It is great to see increased use of LDI strategies and we hope to see growing demand for them along with evolved solutions over the coming years.

Not all schemes are fully hedged at present and more needs to be done as deficits are plugged by company contributions; of the £2tn of UK defined benefit liabilities, just under £1tn of liabilities have been hedged to date.

LDI evolution

As more pension schemes mature and funding levels improve, there is likely to be an evolution of ‘traditional’ LDI and growth strategies to a mixture of LDI and ‘yield-based investing’ strategies.

These allow pension funds to meet cash flows with a higher degree of certainty. However, we continue to watch this space as such strategies have limitations given the current attractiveness of credit and market capacity for more illiquid yield-based investments.

The shape of liabilities is continuously changing due to benefit structure changes, transfers out, mortality changes and buyouts.

As a result, LDI mandates need to be continually reshaped to ensure a scheme is not unexpectedly under or even overhedged.

For example, DB liabilities have been dropping by up to 3 per cent a year over the past few years due to transfers out.

The preferred hedging instrument is liable to change often due to shifts in the regulatory landscape, such as the end of Libor.

In the recent past we have gone from a period of high use of Libor swaps to gilts to a potential increase in Sonia swaps, and pension schemes should ensure they are always aware of the optimal hedging instrument.

The advent of pooled LDI solutions for smaller schemes and the proven track record of LDI for larger schemes has also meant adoption rates are at an all-time high.

We expect this trend to continue to rise as more schemes take the steps necessary to tackling risk exposures.

Paras Shah is head of LDI at Cardano