Up until September 2022, nearly no one had heard of Liability Driven Investing (LDI). This all changed with the gilt crisis and the end of the Liz Truss premiership. When LDI did make it onto the front pages, it was sometimes characterised as a speculative and risky activity. This isn’t true. In fact, LDI is an extremely important risk management strategy that has been embraced by pension fund trustees, sponsors and regulators.
In this post we will describe what LDI is and why DB pension funds use it.
What is Liability Driven Investing for?
In this post we looked at the idea of liability matching. Recall, that a pension fund has both assets (what it owns) and liabilities (what is owes). If these do not behave in the same way, then the financial position of the pension fund will be volatile. LDI is a technique used to manage this volatility. LDI does this by making the pension fund’s assets behave more like its liabilities.
How pension funds use Liability Driven Investing
In last week’s post I gave a simple example of a pension fund that owes a single payment of £1 million, in one year’s time. Recall that if the interest rate the pension fund expects to earn falls, the present value of this payment will increase.
In our example, the interest rate fell from 3% to 2.9% and the present value of the £1 million payment increased by around £1,000. Without a liability matching strategy, the pension fund’s sponsor would need to find this extra £1,000.
However, if the pension fund has a well designed LDI strategy for liability matching, the value of its LDI assets would increase by £1,000 also, completely offsetting (or “hedging”) the effect of the fall in the interest rate.
Conversely, if the interest rate had increased to 3.1%, the £1 million promise would be around £1,000 cheaper to fund. However, the LDI assets would also fall in value by £1,000, so the pension fund’s financial position would be unchanged overall.
In this way, LDI hedges the pension fund against the financial impact of rising and falling interest rates, whether this is positive or negative.
This is captured in the chart below, which is based on the £1 million example above. Note that it uses unrounded values.
LDI tools
In last week’s post we saw how the most natural matching assets are government bonds. This is because they provide a stream of regular payments (coupons and maturity proceeds) which can be paired up with the pension fund’s payments to its members (pensions etc.).
The challenge with this approach is that government bonds don’t offer a very high rate of return. So fully matching liabilities using only real-world assets is expensive.
LDI uses derivatives to replicate the effect of holding real-world liability-matching assets like bonds. Derivatives are financial instruments that literally “derive” their value from real world assets.
LDI derivatives
The most common LDI assets are repos and swaps. These are sophisticated instruments and investment managers and investment consultants spend a lot of time training pension fund trustees on them. We’ll introduce the main features of LDI derivatives here; but leave a more detailed description of swaps and repos for a future post.
An LDI derivative is an agreement between the pension fund1 and a bank. At the outset, the value of these agreements is broadly zero, to both the pension fund and the bank.
However, as time passes, the agreement will increase in value to either party. If the agreement has positive value to the pension fund, it will have negative value to the bank, and visa versa.
In LDI, this value is linked very closely to the interest rates available on UK gilts2. LDI instruments increase in value to the pension fund when interest rates fall. When interest rates rise, the value to the pension fund falls.
LDI is a very efficient way of managing interest rate risk. If the pension fund in our example wanted to fully hedge its interest rate risk using only real-world assets, it would need to commit the full £1 million to do this.
However, with LDI, it would only need to commit about a third to a half of its assets to support the strategy, with the rest of its asset remaining available to earn a higher return. In other words, LDI is a leveraged strategy.
Counterparty risk
LDI derivative agreements can last for weeks, months or even years. In fact, an LDI swap agreement can last for 10, 20 or even 30 years.
The longer the agreement, the greater the risk that one party is unable to fulfil their obligations. The party that has made a profit needs some protection against the risk that the other party either becomes insolvent or simply chooses to walk away from the agreement when it has negative value to them. This is known as counterparty risk.
The most important protection against counterparty risk is called collateralisation, or margining.
Everyday, the bank and the asset manager calculate the profit and loss of the LDI derivatives. Then, the party that has made a loss that day passes assets (usually low risk assets like cash) to the other party. The amount they pass equals the change in value of the derivative over the day. This means that, if the other party ends the agreement early, the party in profit is already holding assets that are equivalent to the value of the contract to them.
In our example above, a 0.1% fall in interest rates increased the value of the £1 million promise by around £1,000. The profit on the LDI assets offset this, as the LDI assets increased in value by £1,000 also. The pension fund wouldn’t actually have to wait until the end of the year to realise this profit because of collateralisation. In fact, it would receive this £1,000 from the other party to its LDI agreement more or less right away.
Collateralisation works in both directions. The pension fund must pass cash to the bank if the LDI assets become less valuable to the fund. An LDI asset manager usually does this on the pension fund’s behalf.
Counterparty risk and leverage
The pension fund (or LDI asset manager) needs to pass cash within a day or so. If not, the pension fund will have failed to fulfil its side of the agreement, which can have significant financial consequences.
This means that the pension fund must have enough cash readily available to meet collateral calls quickly. The amount of cash needs to be sufficient to make the large collateral calls that could occur if interest rates rise very quickly.
How much cash does this mean in practice? The pension fund typically needs to put aside about one half to one third of the value of the equivalent bond.
We will return to leverage, including a discussion of the 2022 gilt crisis, in future posts. In the next post we will look at how matching is relevant for individuals investors, particularly when planning for retirement.
Image by Pexels.
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