 John Dewey, Managing Director, Client Strategy Team, BlackRock Solutions
Unprecedented events have become a regular feature in the financial markets since the Lehman default in 2008, putting further pressure on already stretched funding ratios and heightening the need for an effective LDI approach.
Pension schemes and other institutional investors continue to face challenging times. Economic conditions remain tough and despite some progress, persistent uncertainty in relation to the eurozone continues to weigh on investors’ minds. This in turn has led to a toxic combination of continued volatility in growth assets and lower gilt yields, thereby significantly undermining the average pension scheme’s funding ratio.
This has further bolstered the validity of liability driven investment (LDI), the practice of managing investment risk with respect to an investor’s liabilities.
Pension schemes which have adopted an LDI approach through the management of interest rate and inflation risk, or put in place a ‘journey plan’ to lock in improved funding, have significantly cushioned themselves from the uncertainty regarding both economic growth and robustness of western economies.
Exploiting opportunities through a well-stocked toolkit
When assessing their LDI arrangement, trustees should judge performance in terms of protecting the scheme against adverse interest rate and inflation movements, but also improved returns achieved through using the best instrument at any particular time, minimising the costs of transaction activity and being opportunistic in the timing of risk reduction.
Tools include:
- Locking in inflation rates;
- Crystallising the significant value of existing derivative contracts by re-striking them at current market levels to release capital;
- Increasing the flexibility of the mandate;
- Employing swaptions, total return swaps and repurchase agreements;
- Employing a more dynamic approach to LDI management to enhance returns from opportunities such as quantitative easing and other supply and demand imbalances.
Furthermore, credit risk management has become of paramount importance, whether the exposure arises from corporate bonds, derivative counterparties or sovereigns. The management of collateral should be another area of focus – for instance, investors will want to assure themselves that the quality of collateral is scrutinised closely.
One important element to consider, particularly in light of recent market volatility, is whether the scheme has a sufficiently flexible approach to both the use of tools and the ability of the manager to add value. It is vital to have a governance framework that provides comfort, simplicity and control to the trustees, while giving the manager the necessary freedom within a defined set of investment opportunities.
Longer-term trends
The financial crisis has ushered in an era of increased regulation. On the horizon looms the introduction of central clearing of derivatives and new standards for derivative documentation. Although both of these are evolving, it will bear fruit to keep abreast of developments and the impact they can have on pension scheme investment strategies. Trustees also need to ensure that they are fully conversant with the impact of the Pension Protection Fund’s new levy framework as levy payments will reflect a scheme’s investment strategy.
Slightly further over the horizon are several other developments in the consultation phase that could have major impact on pension scheme investment. First, the European Insurance and Occupational Pensions Authority (EIOPA) is discussing a regulatory framework that could be applied to pension schemes. This regime would subject schemes to a highly restrictive regime akin to Solvency II for insurers and could lead to significant changes in investment policy. Secondly, longer term there is still the possibility that investors may face financial transaction taxes on bonds, shares and derivatives, which could change the viability of certain investment options available to pension schemes.
Are you fully equipped?
All of the above demonstrates that managing a scheme’s investments against liabilities on a static basis is no longer appropriate.
So what can trustees do to optimise their strategy to better reference their liabilities and evolving risk tolerance? The traditional route is for schemes to ask their consultant and asset managers to put in place a suitable investment arrangement while keeping full ownership of the day-to-day decisions. This approach has to be weighed against many schemes lacking the resource and expertise to provide the necessary governance. One way of tackling that issue is to make the decision-making structure more flexible through regular investment committee meetings and to strengthen the internal expertise by hiring independent trustees.
In reality, this option is only available to the larger schemes. Instead, for the majority we see an increased appetite for more holistic solutions. To date such arrangements have been fairly standardised, but the development of integrated platforms and advanced investment technology is leading to the advent of more customised strategies. Clearly this is a significant departure from the traditional model and pension schemes will need to ensure they undertake in-depth due diligence to ensure they are fully comfortable with what is on offer. But provided such solutions offer the right level of transparency and detailed reporting in order for trustees to exercise their governance duties, they provide a credible new way forward to help schemes meet their funding challenges in today’s volatile world.
|
