The liabilities of a pension fund suffer three main risks: interest rate risk, inflation risk, and longevity risk. If interest rates fall, inflation rises, or people live longer, the liabilities of a fund increase significantly.
The LDI hub for a pension fund trying to make full funding has three core roles:
1. First, it gives the pension fund the ability to use a large toolkit of instruments, including bonds (gilts) and derivatives (swaps) to hedge these risks.
2. Second, the LDI hub allows the pension fund to manage its collateral (cash and gilts), which will become increasingly important in 2013 as pension funds start moving to central clearing. [SeeTom’s blog – READY OR NOT, EMIR I COME]
3. Finally, the LDI hub can be used to implement other derivative overlay strategies in the portfolio. For example, a pension fund could synthetically gain exposure to an equity market using an equity future on the S&P500 or a buy put option on the FTSE100 , as a way to gain or in order to protect the downside of their UK equity portfolio.
The role of the LDI hub should be separate from the timing of transactions, and regarded as an ongoing risk management toolkit – not a short-term de-risking task.
For most pension funds the largest risks to the funding level, unless they have been hedged, are interest rate and inflation risk arising from the liabilities. A sharp reduction in risk can be achieved by increasing the hedge ratio: the ratio of interest rate and inflation sensitive assets relative the interest rate and inflation sensitivity of the liabilities. A pension fund that is 80% funded with a traditional 65% equities and 35% fixed income benchmark might only have a hedge ratio of around 20%. In order to immunise the funding ratio to changes in interest rates and inflation, this ratio must be increased to 80%, the risk-neutral hedge ratio. If a pension fund’s goal is to immunise the absolute deficit, then the hedge ratio needs to be increased to 100%. Over the last decade, LDI has become widely adopted with over 600 LDI managers mandated and over £300 billion in assets under management by LDI fund managers (2012 KPMG LDI survey). However, today’s environment is one of low level nominal rates and real yields. The challenge, then, is fitting a view on rates, inflation and real yields against a risk budget and the impact of calling the markets wrong.
“In a strict sense, there wasn’t any risk – if the world had behaved as it did in the past”
Merton Miller – Economist & Nobel Laureate on the demise of Long Term Capital Management
If a Pensions Risk Management Framework (PRMF) document has been laid out thoughtfully, it will encompass all the instructions an LDI manager needs to implement an effective strategy: timing, choice of when and what to hedge, and at what market or funding levels. It will be driven by the goals, objectives and risk budget set out in the framework. An LDI hedging framework for a traditional pension fund might include a disciplined, averaging-in approach over ten years. For example, this may involve increasing the hedge ratio by 6% a year, from 20%, to reach an 80% hedge ratio in ten years’ time. In combination with Step 7, monitoring, the LDI Hub that is informed by the PRMF can be built into a dynamic de-risking strategy, one that allows the dynamic increase of the liability hedge ratio via the LDI hub. Using this technique, it would be possible to move faster in the event of sharp rise in real yields to capture the increase in funding ratio, and to capture the outperformance of the assets against the liabilities. A pension fund, for example, could effect the dynamic switching from equities to increasing the hedge ratio via the LDI hub. Within a well designed PRMF, this strategy could allow re-risking to occur when the PRMF and conditions call for it: a pension fund could, for example, add more equity exposure using equity futures or total return swaps. This dynamic approach can also be applied to other parts of the strategic asset allocation, for example, by switching from shorter dated credit risk premia to longer dated and often illiquid credit risk premia in order to lock-in the re-investment risk needed to fund the plan. See steps 4 and 5.
Like a skilled sailor, the pension fund will always have a clearly defined goal, but will adapt with the seas to achieve it.
“They always say time changes things, but you actually have to change them yourself”
1. If you do not have an LDI hub in place, which may be because you believe rates are extremely low and will likely rise again, I recommend researching and appointing one anyway. That way, you can put in place a dynamic risk management framework that is able to take action when the opportunities arise.
“Markets can remain irrational longer than you can remain solvent.”
John Maynard Keynes
2. If you have an LDI hub in place, review it to make sure the LDI manager has access to the broadest possible toolkit of instruments but is also constrained by a carefully considered and appropriate Investment Management Agreement (IMA). Be prepared for central clearing.