What is liability-driven investment (LDI)?

Annabel West

Associate, Manager Research
(Monday, Aug, 16, 2021)
|   7 mins

10 SECOND SUMMARY

  • The liabilities of a pension scheme are associated with three risks: interest rates, inflation and longevity. Liability-driven investment (LDI) can be used to manage the exposure to interest rate and inflation risks.
  • Pension schemes may employ a different level of LDI exposure (or hedge ratio) depending on whether they wish to protect their funding level or deficit.
  • Pension schemes can introduce leverage into their LDI portfolio in order to gain a greater market exposure than the amount of physical assets they have invested, this frees up capital to be invested into growth assets in order to close the deficit.

Liability-driven investment, or LDI, is something that we at Redington have been advising on since our inception over 15 years ago. LDI is a risk-management strategy which aims to mitigate the interest rate and inflation risks related to a pension scheme’s liabilities.

The key aim of a pension scheme is to pay its members the benefits they’re due, which it will be in a position to do once its assets are equal to the present value of its liabilities (i.e. a funding level of 100% – this is calculated by dividing the schemes assets by the present value of its liabilities). To do this, a pension scheme not only has to invest its assets to earn a suitable level of return but may also choose to manage the present value of its liabilities to avoid aiming for a moving target.

The graphic below illustrates what a pension scheme’s liability cashflow profile might look like. Each bar represents the annual benefit payment the scheme is expected to make to its members.

Due to the time horizon and structure of defined benefit schemes, they are exposed to a number of risks. Some are considered ‘rewarded risks’, where the scheme expects to benefit from taking this risk – examples include equity or credit risk. Conversely, some are considered ‘unrewarded risks’; these primarily relate to the risks associated with the scheme’s liabilities where there is no projected benefit. The main unrewarded risks are:

  • Interest rates: the lower the interest rates, the higher the present value of liabilities.
  • Inflation: the higher the inflation expectations, the higher the present value of liabilities.
  • Longevity: the higher the life expectancy, the higher the present value of liabilities.

These risks are explained in more detail below.

How can LDI help manage these unrewarded risks?

Whilst traditional LDI cannot help a scheme manage its longevity risk (this can be done via instruments like longevity swaps1 and buy-in/buyout insurance contracts2), it can enable a scheme to manage its exposure to interest rate and inflation risks.

The clue’s in the name – liability-driven investment portfolios invest in assets whose returns are sensitive to the same risks faced by liabilities. These assets primarily consist of government bonds, as well as interest rate and inflation swaps3. The idea of this is that the value of the assets within a scheme’s LDI portfolio will fluctuate in line with the value of its liabilities, hence keeping the funding level stable as interest rates and inflation expectations move.

How much LDI exposure should I have?

So, it’s clear that LDI assets can help protect pension schemes from interest rate and inflation risks, but the extent to which the funding level is protected depends on the hedge ratio.

A scheme’s interest rate hedge ratio is calculated by comparing the sensitivity of its assets to movements in interest rates relative the sensitivity of its liabilities to these same movements. Let’s take a look at the effect of 1% fall in interest rates on a scheme that is 70% funded (i.e., the value of its assets is 70% of the present value of its liabilities). We will assume a typical current sensitivity of UK defined benefit pension schemes to interest rates (20%)4 and compare three different scenarios:

  1. The scheme has no hedge;
  2. The scheme has a hedge ratio of 70% (i.e. a hedge ratio equal to the funding level); and
  3. The scheme has a hedge ratio of 100% (i.e. a hedge ratio equal to the present value of liabilities).

The chart below illustrates the starting position for the scheme.

As interest rates fall by 1%, liabilities increase by 20% to £1,200. What happens to the value of the assets and the scheme’s funding ratio depends on the level of hedging in place:

  1. Hedge ratio = 0%. Without a hedge, the value of assets doesn’t change and so the fall in interest rates results in a growing deficit and a fall in the funding level to 58%.
  2. Hedge ratio = 70%. When the hedge ratio is equal to the funding level, whilst the deficit still increases, the funding level is unaffected by the change in interest rates since the value of assets rise proportionately to the movement in liabilities.
  3. Hedge ratio = 100%. When the hedge ratio is equal to the present value of the liabilities, the funding level increases to 75% as a result of a 1% fall in interest rates. This is because the LDI portfolio increases in value by more than that of liabilities. Note that, in this case, the pound value of the deficit remains constant, which is why a scheme sponsor might be keen to hedge on this basis.

Is there a trade-off between investing in LDI and growth assets?

One might worry that investing in LDI comes at the expense of investing in return-seeking growth assets. But there’s a solution: leverage.

Whilst typical government bonds are likely to make up the majority of an LDI portfolio, it’s important to introduce instruments such as gilt repurchase agreements (repos)5 and swaps3, which allow schemes to gain a greater market exposure than the value of their physical assets. This frees up capital to be invested in growth assets to help close the deficit.

For instance, a scheme looking to hedge £1,000 of liabilities could invest in £333 worth of LDI funds with three-times leverage whilst maintaining the same duration and exposure to interest rates and inflation as they would have if they had invested the full £1,000 into government bonds. The remaining £667 can then be invested in growth assets whose returns contribute to improving the funding level.

Are there any risks involved with using leverage?

The effects of changes in interest rates and inflation on assets are magnified when a scheme employs leverage. Taking the example above, where the scheme is three-times levered, if the value of the liabilities fell by 20%, the value of the LDI assets would fall by 60%. Economically, this is the same result as allocating three-times more capital to an unlevered LDI fund and experiencing a 20% fall in value. However, in a levered portfolio, risks are magnified because the LDI assets need to be replenished in time to maintain the exposure. Therefore, it’s important to monitor and maintain a suitable level of leverage.

In conclusion, whilst LDI is a useful tool for managing the risks associated with a pension scheme’s liabilities, there are a few things to consider such as the hedge ratio and the amount of leverage employed.

If you’d like to have a conversation about designing a suitable LDI strategy for your scheme, please get in touch.

 

1Longevity swaps transfer the risk of members living longer than expected (and therefore the liabilities increasing) from a pension scheme to an insurer – the pension scheme pays a fixed cashflow stream to the insurer based on expected longevity and the insurer pays a variable cashflow stream to the pension scheme based on actual longevity.   

2Buy-in/buyout insurance contracts transfer the risk of members living longer than expected (and therefore the liabilities increasing) from a pension scheme to an insurer. Unlike a longevity swap, these contracts require an upfront payment – like an insurance premium. While in the case of a buy-in, the pension scheme retains the legal responsibility to pay members, a buyout transfers this responsibility to the insurer entirely.

3A swap is an agreement to exchange a series of cashflows. For example, in an interest rate swap, one party pays a fixed rate and receives a floating rate (which is linked to interest rates) and vice versa.

4We are assuming an interest rate duration of 20 years. This means that for every 1% change in interest rates, the value of liabilities will change by 20%.

5A gilt repurchase agreement (repos) is a form of short-term borrowing for government bonds whereby the owner of a bond lends this out and uses the proceeds to buy additional bonds – thereby increasing their market exposure.

Unless indicated, these are the views of the author’s and may differ from those of the firm.

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