The area of liability-driven investment is a specialist approach to managing money for final-salary pension funds in the UK, the US and certain other countries. Rising bond yields and inflation, aggravated by the recent ill-fated "mini-budget" of the former Liz Truss administration, put LDI in the spotlight. What should wealth managers think about LDI?
As UK Chancellor of the Exchequer Jeremy Hunt delivered tax and spending moves last week, the recent pension fund liability-driven investment blow-up may have been in the back of some politicians’ minds.
Beyond the immediate episode, a question for wealth managers is whether LDIs have any place in their toolkits or is this a purely pension matter? And what lessons should be learnt?
To recap: In October, former Chancellor Kwasi Kwarteng issued his “mini-budget,” including reversals of tax hikes and a promise to cap skyrocketing electricity prices for two years. While the specifics of his actions are hotly debated, government bond (gilts) yields surged. And one area that was hit hard was the final-salary pension and its LDI model. As gilt yields rose, some of the maths on which LDIs were based were brutally exposed. To try and stabilise bond markets, the Bank of England carried out a £65 billion ($76.7 billion) emergency gilt-buying operation.
LDI is a way of investing that gives a multiple exposure to gilts or other government bonds. For example, for every £1 invested in LDI, a scheme could receive the equivalent of a £3 investment in gilts. This leverage is accessed through specialist funds. Schemes have been using LDI to manage their funding risk because it causes their asset value to move in a similar direction and add magnitude to the value placed on their future pension obligations. It therefore avoids large increases in the funding deficit. A requirement of LDI is collateral.
When there is a fall in government bond yields schemes receive collateral payments, when yields increase schemes must provide additional collateral. This use of collateral is common in financial markets and ensures that leverage levels remain within pre-agreed ranges to manage the operational risks of using leverage. That, at least, is how it is supposed to work.
What wealth managers should know
So much for the pension side of the issue. Wealth managers may have different requirements from a pension plan, but they often do need to invest with clients’ liabilities in mind. They must consider the “full balance sheet” of clients’ lives. There is therefore cross-over between considerations that a pension manager might have and, for example, that of a large family office, or private bank.
“These concepts are not significantly different when applied to a household's fixed and variable known expenses, Yon Perullo, CEO of RiXtrema, a New York-based fintech firm working with financial advisors, told this news service. We asked Perullo if LDIs have a place in wealth management and whether family offices and others employ forms of liability-matching investments.
“As with every investment strategy, the answer depends on the client’s situation, but it is a healthy exercise to undertake,” Perullo said.
“It is hard to know if people understand the risk exposures. Rate risk in the world of family offices/wealth management is a different discussion than in the traditional pension world. Obviously, as rates rise, the bond portfolio’s value will decline – all else equal,” he said.
“But if a $100,000 10-Year Treasury was purchased to provide about $4,000 of annual income, if rates rise and the bond is now worth only $90,000 is irrelevant as it will still provide $4,000 a year for the next ten years exactly as planned. There is no `funding’ requirement for a household, so mark-to-market issues are less of a concern, as are changes in actuarial assumptions, collective bargaining agreements, and other items that can add wrinkles to LDI in pensions,” he continued.
Inflation is weighing on minds.
“In the case of rising inflation, expenses could increase to make the $4,000 cash flow inadequate, but also, the value of $100,000 in 10 years will be less than expected if inflation is higher than forecast," Perullo continued. "Advisors should understand the risks from inflation because that will impact their client’s portfolios irrespective of employing an LDI framework. But forecasting these variables over 20+ years is impossible. This is where flexibility needs to be built into the strategy to enable unknown expenses to be covered – these, of course, are not limited to inflation only.”
There have been signs that LDI strategies were giving some commentators concerns months before October’s UK gyrations.
A webinar held in July, organised by Z/Yen Club, featured a paper in which the author, Dr Con Keating, covered the “legal position of common elements of liability driven investment (LDI) for DB pension schemes.” The webinar introduction went on: “It [the paper] concludes that there are significant risks, that their actions will be deemed ‘ultra vires’, for trustees and LDI investment managers arising from the use of borrowing, the use of derivatives, and the purchase of conventional and index linked gilts as ‘hedge’ instruments.” Further, the paper said: “It appears that the [UK] Pensions Regulator has failed to enforce the law, in breach of their statutory duty.”
Data suggests LDI has lost its allure.
Allocations to LDI strategies slowed marginally to around 13.9 per cent of total assets invested in LDI strategies in 2021, from 14.2 per cent a year before, according to a report in mid-October by the Thinking Ahead Institute. To put that in context, assets under management at the world’s 500 largest asset managers reached a new record of over $131 trillion in 2021.
Returns to LDI strategies are directly related to the performance of gilts and have historically generated positive returns with the secular decline in yields. But rising interest rates have caused losses, also piquing the interest of lawyers. Some pension plan chiefs might be in the legal firing line. This might be a matter for wealth managers to bear in mind if they ever go near something like LDI.
“A professional negligence claim would consider whether LDI was a prudent strategy for the pension scheme, including as part of that question considering whether there was enough liquidity in the fund,” Rachel Healey, of RPC, the international law firm, said in a recent note.