Making Equity Linked LDI Accessible To Smaller Schemes

07 March 2017

image of stones arranged like scales with smaller stones balancing on top of each other on each side

Employing an Equity Linked Liability Driven Investment (EL LDI) is not a new idea. Larger pension schemes have been using similar bespoke solutions for many years. However, JLT Employee Benefits and BMO Global Asset Management, have now packaged this strategy into a low cost and transparent pooled fund, making it accessible to smaller schemes.

Background

Pension schemes have seen escalating deficits in recent years as yields have fallen and, despite strong returns, growth assets have struggled to keep up.

Indeed the latest figures suggest that the combined deficit of the UK’s c. 6,000 defined benefit pension schemes is £630 billion on a scheme funding basis and £1.5 trillion on a buy-out basis.

Much has been made in the financial press of the current methodology for valuing liabilities. What is clear though is that pension schemes require investment growth whilst also wanting to manage the volatility of the funding level.

A growing number of pension schemes use efficient solutions such as leveraged Liability Driven Investment (LDI). However, the dilemma remains of striking a balance between reducing liability hedging to target higher returns; or selling growth assets to target more hedging.

What is EL LDI?

EL LDI is the first solution of its kind to combine leveraged liability hedging and synthetic equity exposure within a single capital efficient pooled fund.

How does it work?

In a traditional LDI strategy a number of relatively simple investment techniques are used to provide leveraged protection against movements in long term interest rates and inflation expectations.

Leverage is a financial term for increasing the effectiveness of an investment without increasing the initial capital invested. This is the advantage of LDI; it typically allows a scheme to protect against £3 of liabilities for each £1 invested, or put another way, to match its funded liability exposure with an investment of 30-40% of the assets.

EL LDI works in a similar way except one part of the exposure to liability matching gilts is replaced with passive global equity.

Equity Linked Liability Driven Investment diagram

Best of both

With increased deficits, DB Schemes are under pressure to maintain the potential for investment growth to improve long term funding, but at the same time to take steps to reduce the volatility of the funding position.

The problem is that with falls in yields, liabilities have significantly outpaced assets and this has resulted in increased deficits and a requirement for greater contributions, an extension of recovery plans or a more aggressive investment strategy. The latter could lead to the majority of the scheme’s assets being allocated to a growth strategy to play catch-up, and accepting an increased level of risk. This leaves very little room for liability hedging; even with leveraged LDI, meaning that putting in place a significant level of interest rate and inflation risk protection is difficult to achieve. 

The benefit of EL LDI means that your hedging allocation can also provide exposure to equity markets. It therefore gives the potential for long term investment growth and removes the compromise between increased returns or increased liability protection.

Is the time right to hedge?

Whilst gilt yields remain low, they are now well above the lows of August 2016.

It is difficult to call the direction of yields, especially in the short term and there remain many uncertainties that could drive yields in either direction. 

Many pension schemes are therefore putting in place strategies to increase the level of liability hedging over time. 

The first step is often to use LDI funds to replicate the hedging provided by a scheme’s traditional bond holding with a lower monetary allocation. This frees up assets for growth, and if EL LDI is used, this would significantly increase the overall growth potential of the asset base. 

The next steps usually involve making further incremental allocations to LDI to increase the level of hedging in a phased manner, either based on fixed time periods or seeking to capitalise on funding improvements.

Alternatives

Other managers are starting to launch similar products which combine their diversified growth strategies with a liability driven investment product in a similar way to the EL LDI fund. 

This can be a strong option if the Trustees have faith in the active manager’s investment strategy. However, it introduces active manager risk as the hedging strategy is linked to the ability of the manager to deliver its active growth strategy mandate. Should the manager under-deliver, or the Trustees lose faith and wish to replace the manager, costs from replacing both the scheme’s hedging strategy and the active growth assets would be incurred, thereby potentially introducing greater transition risk.

With EL LDI, the equity exposure is through equity futures which effectively provide a passive global equity market exposure for low investment management charges and without the active manager risk.

Equity Linked Liability Driven Investment  article chart

Summary

Despite the prevailing low yield environment, many schemes are using LDI to ensure that their liabilities are being hedged as efficiently as possible. 

EL LDI is the latest evolution of pooled LDI which allows schemes to protect against movements in liability values without compromising the long-term expected return of the investment strategy.

If you would like to know more please contact:

Jig Sheth, Head of Strategy | T: +44 (0) 161 253 1154 | E: jignesh_sheth@jltgroup.com

Jim Addy, Investment Consultant | T: +44 (0) 113 203 5819 | E: james_addy@jltgroup.com