The European pensions industry is becoming more familiar with the concept of liability driven investment (LDI) and the benefits it can offer schemes looking to reduce risk, at the same time as maintaining expected returns. While there are many ways of defining LDI, we believe that it can be best thought of as the use of modern investment techniques to create portfolios with a better balance between market risk compared to a scheme’s liabilities and the returns their investment managers are able to achieve. It therefore encompasses a large range of different solutions.

Smaller schemes, however, are finding it difficult to turn theory into reality. They are faced with the challenge of reconciling the costs of implementing an LDI structure with the benefits they would receive in return. For many, segregated portfolios can be prohibitive due to the costs and administration involved. Up until recently there have been few LDI pooled funds available. The ones on offer have generally been passive solutions that immunise a scheme’s liabilities without any prospect of additional performance to improve the funding ratio.

Dilemma of investing in bonds

There are also timing issues, such as the dilemma surrounding investing in bonds at current yields. We believe that, while bonds are relatively expensive and are at historically low yields, they still offer advantages as a long-term investment. For the majority of pension fund liabilities, fixed securities and derivatives are best able to match the two greatest risks faced: namely the changes in interest rates and inflation. While equities and other real assets are likely to show the best performance over the long term, absolute returns are likely to be much lower than the 1980s and 1990s and the volatility of those returns remains high. The closer the match in assets to liabilities the less risk there is associated with the fund.

Implementation issues are also an important consideration. While it is possible to create a portfolio of only physical fixed income securities for liabilities falling due within the next 30 years, realistically it is likely to be constrained to investments that match the cashflows of the scheme without necessarily offering attractive yields. This is because there are a relatively small number of high grade assets in the euro fixed income market particularly in long maturities. Corporate bonds rated AA or higher and with maturities over 15 years make up a very small proportion of the overall euro bond market. It is therefore likely that the portfolio would have to compromise in terms of its yield and diversification.

We therefore believe that, if a portfolio is unable to invest in derivatives and swaps in particular, then adopting the ‘least risk’ or passively managed portfolio precludes generating investment returns in excess of the liabilities. For many funds, this will substantially increase the cost of the scheme as contributions alone must close any funding gap. Most funds will wish to generate returns in excess of their liabilities and will therefore need to move away from the ‘least risk’ portfolio. While it is likely to be appropriate to achieve this by investing some proportion in higher returning asset classes such as equities or property, the use of fixed income derivatives offers the potential to achieve a greater diversification of risk between all parts of the portfolio and thus better returns.

However, setting up the documentation that allows schemes to invest in swaps can be time consuming. Even though there are standardised legal agreements, called ISDAs, the bespoke legal documents are complex. Investing directly in derivatives has governance issues with which small schemes may not be able to cope. There are also custody and accounting considerations, as new systems may need to be put in place to implement the more sophisticated transactions. For larger schemes with the appropriate resources, the benefits more than outweigh these disadvantages. Solutions to the problems faced by smaller schemes are most likely be found in pooled fund structures.

Diving into pooled funds

Using pooled funds takes the headache away from the use of derivatives. They are an important tool to meet outperformance targets for portfolios measured against traditional index benchmarks in a more efficient way with lower transaction costs. For LDI portfolios, we believe that swaps are key to the ability to create liability-matching structures.

Our fixed income team, strengthened by the recent purchase of Deutsche Asset Management, has been developing LDI strategies for over three years and we have built up a large and experienced derivatives team, which focuses on developing investment solutions for clients. We manage more than €4bn in segregated LDI mandates but we also believe that LDI can be of great benefit to small- to medium-sized schemes and have consequently launched the Fixed Income Alpha Funds range so that all our clients can access solutions to their funding dilemmas.

The new funds target an annual outperformance of 2 per cent relative to their respective benchmarks. We aim to achieve this by taking advantage of a number of sources of extra return that are relatively unexploited in global bond markets. Our fixed income investment management team are already focused on this objective and have an established track record. Diversification is key to the investment philosophy. While the funds take larger position sizes than in a traditional bond portfolio, the sources of performance are not closely correlated, thereby increasing the outperformance potential for a given risk budget.

Since clients will want to tailor their exposure to certain markets (sterling, euros and Swedish krona) and maturity profiles, the funds range offers this flexibility. Using swap overlay strategies, a number of funds are available which target different interest rate and inflation exposures. We are therefore able to offer a tailored selection of funds which best match individual client requirements. If a client wishes to target a particular exposure, we will work together with them to agree which combination of funds will best achieve their goals. Subject to the size of investment, we are able to launch additional funds if required.

Evidence for growing market

This market is very much in its infancy but there are strong reasons to believe that it will be a growth area: an ageing population with a smaller labour force yet higher pension and healthcare expenditures; a need for long-dated securities to address potential asset/liability mismatches of pension funds and insurance companies; and an insufficient supply of prime quality long-dated securities. We are excited to be able to meet this demand.

Trustees now not only have the tools to help them efficiently match their pension fund assets to their liabilities, but they also have the flexibility to adjust their investments if the liabilities should happen to change at any stage in the future – both quickly, easily and cost-effectively. Moving to an LDI structure no longer means schemes are restricted to tying up assets in a low yielding immunised portfolio. A diversified fixed income portfolio is crucial to achieving higher performance as the sources of performance are not closely correlated. We achieve this by having separate teams making independent decisions in the various strategies employed. Our fixed income structure comprises four research teams who are charged with generating investment ideas and outperformance in their area of specialisation. These teams are:

• Global interest rates for country allocations, duration and yield curve positions;

• Investment grade credit for issue selection within the investment grade non-government bond universe;

• Currency for exchange rate positions; and

• Sub-investment grade for managing exposure to high yield and emerging markets debt.

Small schemes needn’t be penalised by cost and implementation issues if they choose appropriately structured pooled fund investments.

Contact:

Dominic Delaforce

Co-head of Liability Driven Investment
Tel: 00 44 207 463 6330
dominic.delaforce@aberdeen-asset.com
www.aberdeen-asset.com

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