An LDI benchmark allows you to define the goals of your LDI portfolio, enables the manager to take a dynamic approach to managing the portfolio and is a tool to measure the performance of the LDI manager. My previous blog highlighted the key objectives of an LDI benchmark, but how do you construct one in practice? Here are the 5 key building blocks:
1) Receive cash flows from Scheme Actuary and inflate using the appropriate inflation rate (i.e. CPI, RPI, LPI)
An LDI benchmark is a series of cash flows, these cash flows are based on the liability cash flows of the Scheme. Using a number of assumptions an actuary will estimate the future pension payment cash flows for each year until final maturity and these form the basis of the Scheme’s LDI benchmark. Each future cash flow must then be inflated with the appropriate inflation measure to give the true representation of the liabilities.
2) Discount the cash flows using appropriate discount basis
When deciding the appropriate discount basis it is important to ensure the LDI strategy is consistent with the overall funding objectives of the Scheme. For example: For a Scheme with a primary funding objective to target ‘full funding’ on a liability valuation basis of Gilts+0.50% it may be desirable to use Gilts +0.50% to discount the benchmark cash flows as this will minimise the differences between the Scheme’s liabilities and the LDI benchmark.
3) Calculate interest rate sensitivity (PV01) and inflation sensitivity (IE01) for cash flows at each annual tenor point
Once each of the benchmark cash flows have been discounted, the present value of these cash flows are sensitive to movements in the interest rate used to discount (i.e Gilts +0.50%). This sensitivity is quantified by “PV01” (the change in value of the liabilities resulting from a 1bp rise in interest rates).
Similarly, as the cash flows are linked to inflation (as set out in step 1) they also possess a degree of inflation sensitivity. This is quantified by “IE01” (the change in value of the liabilities resulting from a 1bp rise in inflation).
4) Scale the PV01 and IE01 by the desired target hedge ratio
If a Scheme has a target hedge ratio of 75% at each tenor point the PV01 and IE01 would be scaled down 75%. The corresponding LDI asset portfolio will be constructed to replicate the benchmark PV01 and IE01 with hedging assets and the target hedge ratio of 75% will be hit at every tenor point along the curve.
5) Consider the impact of non-LDI assets held within the portfolio that have hedging characteristics
It’s not just swaps and gilts held in the LDI portfolio that have interest rate and inflation sensitivity, in fact many assets (e.g. corporate bonds) will have an implicit PV01 and/or IE01 that contributes to the Scheme’s hedging. These assets are outside the control of the LDI manager and therefore must be accounted for somehow to prevent over hedging. There are two possible methods:
1) Strip out the PV01/IE01 of these assets from the benchmark at the appropriate tenor points
2) Provide the LDI manager with the PV01/IE01 of these assets to account for when executing a hedge
Once the LDI benchmark has been constructed it can be given to the LDI manager who will use it to construct the LDI portfolio, dynamically manage the LDI portfolio to closely match the benchmark at each tenor point and monitor the ongoing performance of the LDI portfolio.