Getting to the heart of LDI

Written By: Matthew Craig LAPF Investments

With the age profile of scheme members expected to mature, Matthew Craig looks at how local authorities might benefit from the concepts behind LDI

If liability-driven investing (LDI) can be called a state of mind, then it is one that local authority pension funds are beginning to adopt.

LDI can be seen as a conceptual framework for managing pension fund assets. It places great emphasis on managing the risks related to pension fund liabilities, such as interest rate risk and inflation risk, and trying to synchronise the movements of assets and liabilities. LDI was first used by pension funds in the UK around a decade ago, when private sector defined benefit (DB) schemes became acutely conscious of imbalances between assets and liabilities and the need to rectify this. These imbalances were due to factors that do not necessarily affect public sector schemes, or did not at that time. One factor was the use of discount rates to calculate liabilities; as interest rates fell, liabilities sharply increased, irrespective of asset values. Many funds also became markedly more mature in their membership profile, as DB schemes closed to new entrants and, in some cases, any future accrual of benefits. In this situation, a reduced investment horizon concentrated minds on the need to ensure that a pension fund had sufficient assets and could generate the necessary cash flows to meet liabilities as they fall due. Consequently, pension funds following an LDI approach tended to reduce equity holdings, increase matching bond portfolios, use interest rate and inflation swaps to hedge these risks and aimed to return to full funding on a shorter timescale than they would have done. While all funded pension funds have liabilities, LDI strategies start to make sense when liabilities become clearer, with a large number of pensioners in receipt of benefits and a higher proportion of older members whose future benefits can be calculated with reasonable accuracy. The size and shape of the liabilities facing the fund can be used to determine the best matching portfolio of assets and the key risks for the fund.

Now the factors behind LDI are playing a role at local authority pension funds. Changes to the benefit structure of the local government pension scheme (LGPS), the overall demographics of an ageing population, and job cuts at local authority employers are all likely to mean that investment strategies need to reflect a more mature age profile in the future. However, this will not happen overnight; it is likely major changes to local authority pension fund investment will take a number of years to bed in, particularly given the current uncertainty over how the LGPS is managed.

At the West Midlands Pension Fund (WMPF), Mark Chaloner, assistant director (investments) at the fund, said that while LDI is not currently used, it is an area which is kept under review. Asked if there is likely to be a trend towards LDI at public sector pension funds, Chaloner said: “It is very likely that public sector pension funds will make more use of LDI strategies over time as they become more mature.” Like many local authority pension funds, WMPF has a sizeable allocation to fixed income, in its case around 20%, but it is not necessarily designed to match liabilities, but partly as an overall investment strategy of diversifying and seeking returns. Chaloner said that WMPF’s fixed income portfolio is divided into two segments and added: “Around half is invested in ultra-safe UK Gilts in order to stabilise the asset base (valuable in the event of a difficult wider market environment) and to be a source of capital in extremis. The rest is invested in a range of other fixed interest markets with a view to generating higher returns as a component in the fund’s diversified return-seeking investment strategy.”

However, at Surrey County Council Pension Fund, pension fund manager, Phil Triggs, said steps have already been taken towards managing liabilities through its fixed income holding. “We have recently started to apply an LDI approach within our fund. We have allocated approximately £90 million, or 3% of the assets under management, to index-linked Gilts to provide a hedge against inflation risk. We have used some leverage to extend the coverage this gives, but given the recent falls in Gilt yields, it is arguable that we could do with more coverage here. It is certainly a growing issue for LGPS funds, given the exposure of liabilities to inflation and interest rate risk,” he commented.

The £4.9 billion London Pensions Fund Authority (LPFA) could be described as a pioneer among local authority funds in the application of liability-matching. This is because it has a very mature age profile, with around 40,000 pensioners, roughly two-thirds of its total membership, many of them former staff of the Greater London Council and the Inner London Education Authority. In its last annual report for the year to the end of March 2014, the LPFA reported it had reduced the risks of inflation through £1 billion of inflation hedging. On its website, the LPFA states: “Our main investment objective is to ensure that over the long-term, the fund has sufficient assets to meet all pension liabilities as they fall due. The adoption of asset and liability modelling (ALM) is the key to prudent pension fund management.” This comment sums up the approach behind LDI strategies, although the execution naturally differs from private sector DB using LDI.

Indeed, the LPFA’s belief in its ALM approach is a key part of its submission on the future of the local government pension schemes, with the creation of super-pools of assets based on ALM principles. The LPFA website states: “We are developing a coherent, long-term asset and liability modelling platform from which assets and liabilities can be managed effectively.” It adds that this involves creating quantitative models and in-house products to maximise investment returns. Another feature is managing member and employer data to ensure it is up-to-date and correct. The LPFA said that data cleansing, as it is called, has reduced its liabilities by £8 million in the space of a year. The first steps in the LPFA’s plans to extend its ALM services to other local authority funds was announced in December 2014, with the news of an ALM partnership between the LPFA and Lancashire County Pension Fund. This aims to create a commonly managed, jointly invested pool of assets, in order to give benefits of investment scale and high governance standards. Lancashire County Council leader, Councillor Jennifer Mein, commented: “Taking a more proactive approach to the managing of assets and liabilities of the Lancashire County Pension Fund has really paid off in recent years and this new partnership will enable us to build on the expertise we have developed.”

Whether it is called LDI or described as better ALM, it is also important to find investment returns, alongside liability management through hedging and holding fixed income assets. In the past, equity investing was the main route to investment growth, but equities are seen as less suited to a fund using an LDI approach. This is because equities can be volatile and can underperform for relatively long periods. One option for smaller funds is to use a diversified growth fund, which combines various return-seeking assets. The aim is to produce a relatively stable source of returns, which will help close a funding gap. Another approach is to invest in assets such as private equity, housing and infrastructure to benefit from both the illiquidity premium and the ability of these assets to generate an income which can be used to meet liabilities. For the LPFA and Lancashire County pension fund, creating a larger pool of assets could help local authority funds to invest in illiquid, income-producing assets. LPFA chairman, Edi Truell, commented on the partnership: “With a greater pool of assets, both pension funds will gain access to a wider range of investments. It is especially important to compete for desirable illiquid investments against the enormous international sovereign wealth funds and pension investors.”

For local authority pension funds, whether it is called LDI, or asset and liability modelling, it is likely that in future, funds will spend more time and effort on ensuring assets and liabilities are in harmony. The days of having a relatively young membership profile, of being very cash flow positive, and of having a very long investment time horizon are gradually changing. Over time, we should not be surprised to see an LDI state of mind at more and more local government funds.