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UK’s Liability-Driven Investing Evolves

UK’s Liability-Driven Investing Evolves

Apr. 19, 2018

Apr. 19, 2018

The weight of UK pension deficits has come to the fore once again this year, with many companies struggling with their financial liabilities.  

BT Group, the telecommunications giant, has agreed to close its defined benefit (DB) pension scheme amid a 14-billion-pound (16-billion-euro) deficit.1 Building contractor Carillion, which filed for bankruptcy in January, has left a 990-million-pound pension gap.

Asset mismanagement, falling bond yields and increased life expectancy have left British employers with explosive DB pension shortfalls. PwC estimates that the total unfunded gap among 5,800 UK sponsors of private DB plans is £450 billion.2

Given the shortfall’s size and pressure from regulators, pension trustees were in recent years forced to reconsider their investment approach and prioritize de-risking.

Thus, liability-driven investment (LDI) strategies, which aim to minimize the diversion between the present value of assets and financial commitments, found a new impetus this century as a solution to the funding gap problem. With LDI, liability cash flows became the actual benchmark for performance.

How LDI works
DB schemes know their liabilities. There are, however, unknown variables that affect them – most importantly, interest rates and inflation.

The simple solution to this problem is for a scheme to invest in assets that have similar interest rate and inflation sensitivities to liabilities, so that changes in the current value of the liabilities will be offset by changes in the value of the assets. For many portfolios, this has meant buying low-risk, long-duration government bonds and, more recently, investment grade corporate bonds.

Successful LDI approaches help pension schemes lower their funding level volatility by immunizing their assets against the risks stated above.

LDI strategies are going as strong as ever. The total notional value of liabilities hedged by LDI strategies more than doubled in the five years to 2016 to £908 billion, according to KPMG.3 A total of 1,808 pension schemes now use LDI, or around three times the amount in 2011, KPMG says.  

Where initially LDI was a very bespoke concept and only efficiently implemented by the larger schemes, demand from small- and mid-sized pension plans led to the development of pooled solutions that can benefit from economies of scale.

A growing industry on the cusp of change
The next phase for the LDI industry may see it address some of its pitfalls, such as a continued liabilities mismatch, inefficient portfolio construction, unsatisfactory management monitoring and lack of clarity on roles and responsibilities. The absence of independently calculated LDI benchmarks is at the core of a number of these issues.

To present a solution to these challenges, STOXX will introduce next week the first suite of LDI indices for the UK market. The aim of the iSTOXX RiskFirst LDI Index family is to offer pension scheme trustees and consultants a complete set of building blocks to select and monitor LDI managers, construct portfolios efficiently and approach risk and asset management in an objective and low-cost way.

The iSTOXX RiskFirst LDI Indices track the performance of corporate and government bonds denominated in sterling. A range of indices based on 12 distinct liability profiles captures member type, duration, indexation type (pre- and post-retirement), interest rate and inflation sensitivity, and the tax-free cash component of typical UK pension schemes. The offering has been jointly developed with RiskFirst, the UK’s leading provider of risk analytics and reporting solutions to the DB pensions market.

A best-in-class cash-flow matching approach and quarterly rebalancing allow the LDI indices to provide a closer match between assets and liabilities. Four different sets of indices are provided:

•    nominal bond
•    inflation-linked bond
•    blended
•    non-gilt

A tailored combination of the available LDI indices, based on the nature, duration and shape of the liabilities, can become the investable benchmark for LDI allocation. The indices function as flexible, investable building blocks for LDI portfolios.

LDI session at STOXX’s conference
A session during STOXX’s Innovate2Invest annual conference next week will be dedicated to LDI, and particularly how indices can help address governance and portfolio construction challenges. The conference, under the title of “The Future of Investing and Investing in the Future,” will take place on Apr. 25 in London.

Getting the right hedge is the crux of an LDI strategy, and crucial for the many British pension plans seeking to overcome their shortfalls.

1 Nic Fildes, ‘BT strikes deal with union to close defined benefit pension plan,’ Financial Times, Mar. 19, 2018.
2 PwC, ‘UK pension deficit climbs £40bn in November, according to PwC’s Skyval Index,’ Dec. 1, 2017.
3 KPMG, ‘No end to growth in sight,’ June 2017.


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