The Death of LDI?

In some locales, the theory of liability-matching is coming up against the reality of markets.

At the end of last year, the Dutch pension system was insolvent.

A plummeting discount rate dragged down the asset values to levels at which it is necessary for pension funds to consider the unthinkable: cutting pensioner benefits.

Yet this was a country long lauded for its innovation, particularly with regards to de-risking. Liability-driven investment (LDI) has been the norm for most funds for years. What went wrong?

“Everyone wants to engage prudent risk management but if the return doesn’t look good enough then you have to step back from LDI.”“There is a distinction to be drawn between how relevant LDI was in the past and how relevant it will be in the future,” says Rupert Brindley, managing director in JP Morgan Asset Management’s pensions solutions and advisory group. “For Dutch pension funds, the LDI portion of their portfolios is the part that is going to have done the best.”

As government bonds have rallied during the past few years, LDI strategies have ticked along and performed exactly as they were designed. As these assets continue to increase in price, however, the upside diminishes. In other words, the current problem experienced by many Dutch funds may be down to other underperforming asset classes, but investors shouldn’t expect a previously successful LDI mandate to haul you out of a deficit in the future.

“If you are invested 100% in LDI then you are now looking at a 1% nominal return over the long term,” Brindley says. “There is not much point running a pension scheme if you’re going to put it all into LDI because it is not economically viable.”

If government bond yields continue to fall, Brindley adds, “we are going to have to ask some very difficult questions about this pension design… I would find it very hard to see why a 1% nominal yield would be attractive in the long term. That’s a discussion you have to have when you’re looking at locking down the strategy of your plan.”

If your LDI portfolio is only earning 1% a year, that is not going to be enough to close a deficit, Brindley says.

Over the English Channel in the UK, pension funds in the public and private sector will likely be bemused by the consternation in the Netherlands. Dutch rules are such that talk of insolvency and benefit cuts materializes when many funds are still recording funding ratios in excess of 100%. (Ratios need to be above 110% to permit any form of indexation for pension payments.)

The aggregate deficit of the UK’s nearly 6,000 defined benefit pensions has grown massively in two years from £76.4 billion ($107 billion) in January 2014 to £304.9 billion at the end of last month. That’s an aggregate funding ratio of just 80.5%, and the sound you just heard was a bunch of Dutch CIOs collectively wincing.

LDI is a “pretty essential” part of risk management for UK pensions, says consulting firm Redington’s Dan Mikulskis, head of asset and liability management and investment strategy.

“You have to make sure you build your LDI strategy robust enough to withstand these shocks.”The country’s aggregate deficit, coupled with the volatility of liabilities, has made LDI an increasingly popular choice in the UK, Mikulskis adds. Those employing the strategy already are experiencing “substantially less volatility in funding levels,” he claims.

“There is still a huge amount of liabilities that have not been hedged, and that’s what is driving demand,” Mikulskis says. “LDI is about risk management, not about timing markets.”

Interest rates in both the UK and the Eurozone may be at record lows of 0.5% and 0.05% respectively, but Mikulskis warns that this doesn’t mean investors should forget about hedging against lower rates.

The European Central Bank has already cut the bank deposit rate to negative, while central banks in Japan, Sweden, Denmark, and Switzerland have already employed negative interest rates. Mark Carney, governor of the Bank of England, has reportedly dismissed the notion of adopting negative rates but admitted they could go lower.

“Getting people comfortable with that risk is a key starting point for LDI,” Mikulskis says. “You have to make sure you build your LDI strategy robust enough to withstand these shocks.”

JP Morgan’s Brindley argues investors should not be afraid to reduce their reliance on a tool that has served them so well in the past. CIO’s latest survey of the LDI landscape, published last November, found that the average proportion of pension portfolios dedicated to LDI had fallen substantially from a year earlier, from 51% to 41%. At the same time, 56% of respondents said they were willing to re-risk their portfolios if necessary, up from 44% in 2014.

“Everyone wants to engage prudent risk management but if the return doesn’t look good enough then you have to step back from LDI,” Brindley says. “That tension is playing out right now.”

Related: 2015 Liability-Driven Investment Survey