Video ID:
8671
Job Number:
6885
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Description:
Mike Walsh of Legal & General Investment Management, Lucy Barron of AXA Investment Managers and Niall O'Sullivan of Mercer discuss LDI in this Institutional Masterclass.
Bookmarks:
0|LDI
258|The LDI journey
501|Hiding a problem
987|Developments
1188|Measuring inflation
1621|Willingness
2142|Giving up discretionary power
2477|Eating everybody's lunch
Duration:
00:45:45
Recorded Date:
29 November 2012
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Transcript:
Presenter: Hello and welcome to this institutional Masterclass with me, Mark Colegate. We’re looking at liability driven investing, and we have an expert panel. Let’s meet them. They are: Mike Walsh, Head of Solutions Distribution at Legal & General Investment Management; Lucy Barron, LDI Solution Strategist at AXA Investment Managers; and Niall O’Sullivan, Head of Investments, Dynamic De-Risking at Mercer. Well, that’s our panel; let’s get straight into this LDI session. Mike Walsh, first of all could you tell us where has LDI come from to the present day?
Mike Walsh: Well if I cast my mind back to 2001 when Legal & General put in place the first LDI strategy for a UK pension fund that was very much focused on matching cashflow liabilities. Now those strategies for that client and for our broader range of clients have really evolved over the past ten years. Not to just look at the liability side of things, so the interest rate and inflation risk, but at the moment to also look at the asset risk within a pension scheme, so to look at both sides of the balance sheet. If I think about our business at the moment, approximately £190 billion for our pension fund clients on the LDI side, almost £50 billion of that is in relation to non-traditional instruments to hedge more asset risk rather than just the outright interest rate and inflation risk.
Presenter: Okay, Lucy Barron, that’s where we've come from, where are we today? What are the developments that you're seeing in LDI?
Lucy Barron: I think we've seen from the earlier stages of LDI it was people looking at bonds and doing fairly simple strategies. I think what we’re seeing now is a wider range of instruments to take advantage of effectively the cheapest hedging instruments. We've seen a lot of market volatility since 2007, 2008, and that’s led to a lot of opportunity in terms of LDI. Whilst market levels are not fantastically attractive for doing LDI typically at the moment, what we have seen is lots of way to kind of cheapen the hedge and take advantage of those market conditions.
Presenter: Okay, so it’s looking for value for money. And, Niall O’Sullivan, we talked about the past and the present, where might LDI go in the next ten years?
Niall O’Sullivan: I think there’s two things: one is Lucy touched on the evolution of rates over the next while could provide interesting opportunities for more hedging. The interesting thing to be will to see whether we've had opportunities to lock in hedges before and we haven’t taken them because it’s behaviourally very difficult to fight against the trend, and bond yields start rising they will get cheaper again in the future. So one of the things that will be important will be to remove emotion from that decision and make sure that you have a clearly defined path for how you're going to implement the hedges when you get there.
The second thing I think is interesting is the regulatory pressure that’s coming. So coming out of Europe there is increased pressure from the EIOPA to make pensions invest like insurers, and insurers hold typically more bonds than pension funds do. So, again, as you move down the track, you could find regulatory pressure forcing even more LDI driven investment strategies coming through.
Presenter: Mike.
Mike Walsh: Yeah, I, just on the second point, I definitely agree with that, and I think as the regulatory pressure maybe forces pension schemes to hold more reserves or more bond like assets, it also increases the likelihood than many companies will look to pass their pension schemes over to an insurer. So, if I was to think how LDI might evolve over the next five years, I think we’ll see a lot more schemes, as well as hedging out the inflation and interest rate risk, look to hedge out the longevity risk and ultimately, if they can afford it, pass the pension scheme over to an insurer and concentrate on the day job for their company rather than managing the pension scheme.
Niall O’Sullivan: I was going to, to agree with what Mike says, I think you can probably divide it into two parts: one is the journey to get to a point where you are significantly de-risked on whatever basis you want that to be; and then it’s going to be well what choice do you face then? Do you decide to remove the problem in one sense by moving to a buyout, or do you decide that in terms of a pricing front you'd prefer to keep it in house and maybe manage to a less risky basis? In a sense that’s a high quality problem to have, because either way you're significantly de-risked. I think the next part of the journey for LDI would be getting to that point where you can afford those strategies.
Presenter: Well, given that, I mean Lucy how long is the LDI journey? Even if the end is a sort of perfectly a happy pension with very little deficit or a buyout, I mean how long should these journeys take?
Lucy Barron: Well LDI is all about helping pension schemes have the money to be able to pay all of their pensioner payments as and when they fall due, increasing the certainty of having that money. So clearly we’re seeing increasingly pension schemes closing to new members, or even to future accrual, which means that the pension schemes are becoming more mature and getting closer to that end game, but pension schemes still have a significant period of time for which they're going to be paying out the pension benefits. And in terms of lots of schemes want to do LDI, lots of schemes have started down this journey, but clearly, in terms of affordability, it’s going to take some time for them to be in a position to get a significant way down that LDI route.
Presenter: Mike.
Mike Walsh: Yeah, I'd agree with Lucy: it’s not a short journey. I read actually a really interesting article yesterday. It was an interview with the Group Treasurer of the Rolls Royce Company. Back in 2001 they found themselves in a really tricky situation where the pension scheme deficit was greater than the market capitalisation of the company, so they had to do something about that and, as the article expanded, they put a plan in place, and that plan partly evolved a point in Legal & General to help them manage through this journey over the past ten years, and it involved not just the liability hedging but reducing their asset strategy from 80% in equities down to a much more manageable 20%, and they find themselves in a much better funded position today compared to where they were back in 2001.
Presenter: Are they? I mean being heavily overweight bonds at this point in time, is that a smart thing to do?
Mike Walsh: It’s probably the main topic of today, which is why, what are you trying to achieve, so it’s really about putting a plan in place for each specific pension scheme. A pension scheme’s ultimate aim is to pay pensioner liabilities; hence for that scheme in particular it was about removing the volatility in their funding level on a regular, on a yearly basis. So by investing more in matching assets and implementing a hedging strategy such as LDI, they were able to lock down the gains in their funding level so that going forward they don’t need quite as high a return from the return seeking assets as a scheme who’s lowly funded and hasn’t implemented a hedging strategy.
Presenter: Niall.
Niall O’Sullivan: I was going to say that gets to the heart of what we mean by LDI or liability driven investing. What we’re saying is we’re going to buy assets that match the liabilities. Not necessarily for their investment characteristics or because they think they're going to do phenomenal returns in the future, it’s because the idea is to arrive at a point where you have assets that mirror your benefits. So therefore if you're looking at say benefits that are being discounted off a gilts basis, then a significant holding in gilts will match those liabilities. It’s not about saying whether they are cheap or expensive, that’s about designing a strategy that’s appropriate to each individual firm. Because one size won't fit all, and there are situations potentially where you have a very strong sponsor that’s prepared to take a lot of investment risk, but ultimately you can look to a strong covenant and say that I would be happy to take more risk in that situations. In other cases you might have a very weak sponsor or a scheme that is considerably bigger than the size of your sponsor, so in those situations you really have to invest in assets that move like your liabilities, and so therefore that’s the aim of the investment.
Presenter: Okay, Lucy.
Lucy Barron: I think Mike and Niall touched on the key points, which is customisation for each individual scheme has their own liability profile and they have their own drivers in terms of strength of the employer and so on. I think LDI’s really, you know, we've got to give people the required customisation and give them the level of control that they want in terms of meeting and designing their strategy.
Presenter: But if you’ve got a system which issues say, you take the pot of assets in the pension fund and you say let’s really take some of these out and look at how these can match future sort of cashflows you need, and then we've got this smaller pot of risk assets over here that we’re investing for growth, it all sounds great, but isn’t there a danger that with all this professionalism and all this way of slicing and dicing, it’s hiding a big problem which is there’s just not enough money in the pension scheme, full stop, and you're kind of creating a bit of false hope?
Niall O’Sullivan: I think when you say there’s not enough money in the pension scheme, it all depends on what you're doing is you're arriving at a present value of a stream of payments into the future. So the interest rate you choose to discount those at doesn’t change what you're going to pay into the future; it just changes the present value of them. To give you another example, I obviously come from an Irish heritage, over the course of the last years there’s been a lot of discussion there about moving to Irish government bonds the discount factor. If that happened, immediately most pension funds would be fully funded, because the discount rates are a lot higher; nothing has changed to the benefit payments they're going to make.
So really when you say there’s not enough money in the system, what you're really saying is that the interest rate that you're choosing to discount the benefits at is very low, and that therefore the liabilities are looking quite high. I think by any sort of historical measure interest rates are low, but it does get back to what the aim of the process is: the aim of the process is to make sure you have enough money to match those benefits. So therefore when we say things are underfunded, yes I think the regulator is looking at it by saying that you don’t want a situation where the pension scheme can penury the employer, that it should be working together to a solution, but as part of that solution a significant holding in bonds is required, and to say that there isn’t enough assets in the system, well that just depends on how you're going to discount those liabilities.
Presenter: Lucy, if I bring you in, because we touched on earlier longevity risk, and we’re all talking about inflation risk and interest rate risk, but how big a problem is longevity risk going to be in LDI?
Lucy Barron: It’s one of the key liability risks, you said exactly, the three liability risks, if you just focus on the liabilities, are interest rate risk, inflation and longevity. It’s therefore this then a number of asset risks, such as the fact that you're holding equity and credit so on. To date, I suppose longevity’s taken some extent of a backseat, because people have had significantly higher holdings of equities that have caused a lot of volatility in the funding level, and then the next major risk they’ve focused on has been the interest rate and inflation risk. But as those risks are reduced, then schemes are focusing on reducing the longevity risk and managing it. In a very similar way to the LDI strategies that have been used to manage interest rate and inflation risk, i.e. putting in place contracts, in some instances, and using assets that they’ve got to support a longevity contract. Clearly the other option is buyouts for certain schemes, but it depends where they are in the journey. Again it comes back to customisation. It depends on the size of the scheme, how well funded they are, and things around the employer covenant, how strong the sponsor is.
Presenter: But how do you hedge out longevity risk, given that people keep living longer and longer, it’s quite hard to sort of get a definite conclusion on?
Mike Walsh: And I guess that’s the crux of the matter is many pension schemes have found that on the tri-annual valuation the actuary’s coming back and saying so our assumptions for how long people in your scheme are going to live haven’t been as prudent as they should have been and we now need to increase that. And so, as Lucy says, as you started to manage the other risks in your scheme, your equity risk, your interest rate inflation risk, then longevity risk becomes a bigger portion of the remaining risk. I think there’s been an interesting anomaly in the market over the past year, although gilt yields have been very low for pension schemes that have hedged a certain proportion of their liabilities with gilts, they were actually able to pass those gilts to an insurer and effectively do a buy-in so you can get the longevity hedging for free, based on the difference in the yield and the gilts versus what an insurer would invest their asset strategy for a buy-in on. So it was a good time or it is still a good time for maybe adding longevity hedging to a portfolio if you’ve already managed the other risks.
Niall O’Sullivan: And one of the other issues on the risk side is longevity has been a victim of the fact that when something increases constantly, it constantly gets better. There isn’t actually any risk in that sense: 1% per annum isn’t risky but it’s consistently hurting you. So the models that Lucy referred to earlier on have been calibrated to catch changes. So equity markets are quite volatile, rates have been quite volatile, longevity is a problem but it’s very steady. So the models that pick up risk tend to underestimate longevity as a result.
Presenter: But presumably if you start to underestimate longevity over a long period of time, there’s a sort of compounding effect, isn’t there, and I mean by the time it appears on your risk screen it’s presumably far too late?
Niall O’Sullivan: Well I think it’s always been taken through in drip by drip every time you do the valuations, which Mike would refer to earlier on, but ultimately when you get to the higher levels of funding that Lucy talked about, it becomes a much bigger part of the risk puzzle.
Presenter: And we've been talking about interest rate risk. I'm just wondering if rates start to rise faster than the market’s anticipating at the moment, what could that do to your LDI strategy? What are the potential downsides there?
Mike Walsh: Well I think one of the interesting things we started talking about interest rates being very low and Niall mentioned that actually the first thing to do is look at where your position as a pension scheme is, if you're significantly underweight interest rate exposure, so your liabilities have a lot of interest rate exposure and your assets don’t, despite it being low levels, to get that risk under control you might actually look to add some interest rate hedging in an LDI strategy. Then if interest rates rise, the value of your liabilities will fall, but as will the value of your LDI strategy, because the idea is they move in tandem, but clearly because you’ve only hedged a portion of your liabilities, the value of your liabilities will fall faster than the value of your, by more than the value of your LDI portfolio, hence it’s actually still a positive thing for the pension scheme as a whole.
Presenter: Okay, Lucy, I was thinking you wanted to come in there.
Lucy Barron: Yeah, I mean you're right, low interest rates are an issue, you know, and quite a number of schemes are saying we don’t want to do a significant amount of LDI or de-risking with 30 year gilts at around 3%. So what they are doing, and I think this is absolutely critical, is just having a plan, and setting the framework for what would happen when interest rates, if interest rates rise significantly from these levels. And just, I think Niall mentioned earlier, taking out that emotion, saying okay if we’re not happy doing a significant amount of LDI at these levels, what’s the right level? Is it 350, is it 3.5% as a rate of interest, is it 4%, and what would we do in those situations? But also I think as well as having a plan, it’s being flexible, giving your LDI manager a mandate that allows them to buy the right instrument. Because if we've got two equivalent hedging instruments, say a government bond, a gilt or a swap, we don’t know which of those will effectively reach 3½ or 4% first. So just having a framework that enables you to buy the instrument that’s the best value through time, I think that’s a key part.
Niall O’Sullivan: I think the other thing to think about is everybody, if you were to ask are gilt yields too low, they’ll say yeah they're very low. If you also ask them for the next five years do you think the Bank of England are going to keep short end rates or very short dated rates very low, I think most people would say yes they are. So then you look at, you know, if you think of a 20 year gilt and you're getting a 2.6, 2.7 return on that, you’ve got to compare that to the alternatives. So let’s say I'm going to put money on deposit for a year and roll it over and over again. Well if you're correct on that second statement and rates stay low for that next five years, then rates probably have to average out at closer to 4% for the remaining 15 years for 2.6 to have been not a good idea. So everybody is looking at the absolute number, but the conditions of what are going on and the relative between the various other investment opportunities are important to consider as part of that.
Presenter: Lucy.
Lucy Barron: And I think that’s one of the developments we've seen in the LDI discussions that have happened over the last few years: people haven’t been just focusing on the headline number; it’s been looking at okay bank rates are ½% now, where do we think they're going to go to and, as you said, does an LDI strategy hurt you if rates go up? Well it only hurts you if rates go up faster than the market implies they're going to go up, and the market is implying that rates are going to increase significantly a few years in the future.
Presenter: Does the market have a good track record, I suppose is the next question, on predicting where rates go and how quickly?
Niall O’Sullivan: I mean the market is obviously at any point in time looking at an average of. I mean the 20 year rate is just an average of where we think the other rates are going to go. And with the best will in the world significant changes come through, and I don’t think anybody saw the crash in 2007/2008 coming through and the resulting absolute reduction of interest rates to levels that haven’t been seen since the 1700s to get those lower. So in that sense the rates that were predicted then versus what came through were clearly very different. That’s actually why you should be considering LDI, because, if you don’t put a hedge on, what you're doing is exposing yourself to those moves. Whereas, if you put a hedge on, what you're trying to do is put assets that you own that match the liabilities that you owe. So therefore having a position where the assets that owe mirror those actually removes risk, not adds them.
So, in a sense, if you got to a point where you could afford to buy out the payments, you would have a situation where if interest rates go up or down, your liabilities move but your assets move in tandem and then an overall basis the fund is equal. The only thing I would say is don’t ever think that that would remove all risk, because I mean what you're dealing with here is pensioners and ultimately all sorts of things can happen to the liability side, but it certainly reduces a large quantity of the risk.
Presenter: Because LDI, I think to make the point is, you're saying it’s sort of risk management rather than getting rid of risk altogether?
Niall O’Sullivan: Exactly.
Presenter: Mike, you wanted to.
Mike Walsh: Yeah, most definitely, I'd agree with what Niall’s just said on rates, but a big factor for pension schemes as well is inflation and long term inflation rates, and as everybody knows long term inflation levels is very much driven by supply in the market. So, although you may not think long term inflation is at overly attractive levels, although a lot of our pension schemes clients have been hedging it over the past year, if you think about the demand from pension schemes for long term inflation instruments, it’s only going to get greater and greater over the next ten years. So long term inflation rates are sort of anchored from, or held up from getting too low because of that demand versus the supply factor.
Presenter: So is, you know, however expensive you think inflation hedging is today, it’s probably, getting in today, it’s a bit like house prices, it always, in ten years’ time you'll look quite smart?
Mike Walsh: Well, clearly, we can't predict the future, but there’s a lot of factors that are impacting inflation, so most recently this CPAC consultation as to whether the calculation of RPI should be amended in the future has actually already started to be reflected in the price of inflation in the market. We've seen it dip down to 3% for long term inflation, and it’s those sort of dips in the market that clients, as Lucy mentioned, have a plan in place, it allows their investment manager to get in and pick that inflation up for them when you do see anomalies in the market.
Presenter: And is there, it could be a danger, it could be an opportunity for pension schemes, the authorities, whoever they are, just sort of say actually we’re going to measure inflation rather differently from now on, that could make everything look an awful lot better or an awful lot worse, and that’s almost like a political risk?
Niall O’Sullivan: Yeah, I think the answer to that actually does depend on case by case situations, because in a lot of cases a lot of benefits have already moved to a CPI type measure. So, in those situations, the movement that is happening at the moment is probably more of a harmonisation towards CPI. So nothing specifically going to happen to consumer price inflation, which is already the benchmark used by the Bank of England; it’s more that RPI could be moving towards it. What that means is the assets are definitely affected, because all the index linked bonds that are out there reference RPI and most of the, and the swap market that has gone up is predominantly RPI; there’s some limited CPI but very, very small.
On the liability side, it depends. Certain people will have most of their benefits linked to RPI; certain people have their benefits linked to CPI. It’s a case by case situation that requires careful analysis in each case, and on that point of view, clearly, the lowering of the benefits does make the targets easier to reach. But funnily, as Mike was saying about the stories, we were in a meeting a few weeks ago and somebody said this is great, we can meet our benefits, and then a voice came from one side said unless of course you're a pensioner, in which case it isn’t great.
Presenter: And Lucy, if we bring you in, we’re talking about inflation risk, what are some of the hedges that you can put in place? There’s index linked gilts, what else is there that you could customise for a client?
Lucy Barron: So the main tools are index linked gilts and inflation swaps, and when we say index linked gilts, if we’re just talking about hedging the inflation component, it’s a combination of instruments, it’s index linked gilts combined with another instrument, in this case an interest rate swap. But I think increasingly we’re seeing clients demanding a wider range of assets with inflation sensitivities to be used and incorporated as part of that, and I think, so that includes instruments such as social housing, infrastructure assets with inflation linkages and so on. I think the key thing for us as an industry is to be able to incorporate and make use of all those different assets to enable clients to hedge the amount of in this case inflation risk that they want and to better manage their overall risk.
Presenter: Mike, I mean you were talking about asset hedging a little earlier on in the programme, and all these different asset classes that are coming out, can pension schemes make full use of them? I mean something like infrastructure’s probably quite illiquid, but it seems that everybody has to value exactly where they are more and more frequently, and is illiquidity a problem?
Mike Walsh: Well, for a pension scheme, first and foremost, they are a long term investor. If you're a long term investor, you can take more advantage of the illiquidity premiums, so the higher return you can get from investing in areas such as infrastructure. Clearly, clear valuations, having an understanding of what the assets you're holding is important, but more and more there’s becoming easier ways for clients to access alternative assets and a greater diversified range of assets via areas such as diversified fund, which has been a big trend for pension schemes moving out of growth assets and equities into a pre-packaged diversified fund, which gives them access maybe not directly to infrastructure but through index versions of infrastructure, so it gives them some degree of diversification benefit.
Presenter: Well, one thing, everything we’re talking about, and Lucy if we could pick you up on this, is how is the way that pension schemes are managed and report changing as a result of LDI? Because you keep stressing customisation, the need to be able to move quickly across a range of instruments, how is that affecting the whole way that pension schemes are run?
Lucy Barron: Well I think one of the key things has been a governance challenge and a kind of knowledge requirement as a result of moving into these new strategies. So, clearly, if you're going down the LDI route, you're trying to manage these risks and reduce these risks, but you are introducing new risks and challenges: you're introducing new instruments and you're introducing new instruments that you have to understand. So there’s clearly been an amount of understanding and knowledge required from those groups to be able to do that. Different groups have different governance structures. Some have, as we say, bigger governance budgets than others. The ones that have a high level of governance quite frequently want to take more control over the exact instruments used in the strategy.
We see other clients that want to be able to delegate some of those decisions to the manager, but they want to keep the appropriate level of control and governance oversight. The way that we’re doing that is to have a customised liability benchmark for every individual client, for the client to be able to give us management parameters that determines what’s their appropriate hedging instruments and what’s their tolerance around how those instruments are used, and that we can then report back to say to them your liabilities have gone up by this amount, they’ve moved from 100 to 101, your assets have gone up from X to Y, and this is how that’s happened. So I think in terms of being able to report clearly to them, and the level of knowledge they’ve had to attain, I think that’s two of the key developments.
Niall O’Sullivan: I think you look ten years ago, if you were going out to a trustee meeting, it would have probably been, you know, what are your tips for UK stocks, and we would have talked about how an individual manager did against the FTSE. One of the big lessons to emphasise Lucy’s point again is that we’re now sitting down and saying since we last spoke, your liabilities have done this, your assets have done this, your funding level has done this, and the reason it has moved is because your growth pot has done this and your matching pot has done this. And actually there’s a recognition that the individual elements have to be looked at in that whole, as distinct from focusing in on a specific stock that has been selected, which is interesting but probably not very important at the end of the day.
Taking the point on governance, I mean ultimately that’s the business that I look after, is because large amounts of people are finding their governance budgets are so stretched that to look after both the growth side of things and picking the diverse range of assets which Mike would have talked about, and managing the liability and all the solutions that come with that, require far more than they were used to in the past, and hence our working with fiduciaries to try and take on some of that responsibility.
Presenter: Mike.
Mike Walsh: Most definitely the governance burden has been increased and trustees, I think a clear trend we've seen over the past five years has been much more engagement and involvement by the corporate side of pension schemes. Ultimately, this is, the pension scheme deficit appears on the balance sheet of the corporate, LDI will help you manage the risk, but as you mentioned earlier one of the key aspects is plugging the hole with additional contributions. So tying up the corporate’s desire for risk control and a manageable level of contributions with the pension trustees’ desire to ensure they can pay pensions at the end of the day has meant both parties coming to the table with their investment manager and investment consultant to work out a solution that works for that specific scheme; as Lucy mentioned, it’s very much how’s your liabilities done and how has your liability hedge done relative to that.
Presenter: And given we keep being told, going back to companies, that the UK PLC is in fairly good shape and quite cash rich at the moment, how’s that affecting the willingness and the ability of companies to put money into the pension schemes at the moment?
Niall O’Sullivan: I think it’s the size of the problem. I mean yes, in a lot of cases they are, certainly with cash shores that weren’t there before, but a lot of that press that you read about, that is very much at the higher level, the larger companies that are finding that things are easier. When you get to the smaller level, you know, the middle and smaller companies are finding it harder and harder to raise finance because of the drying up of bank debt, bank loans, etc. So therefore they are probably not finding things quite as easy as the press would have it.
Secondly though what a discussion like this allows to happen is that you can actually frame the conversation in a way that all parties understand. So you can sit down and say okay we have a plan in place that we are going to increase our hedge ratios as we get the opportunity, that we’re targeting being fully funded at a point in the future, and as a result a sponsor can sit there and say well in the past when I gave money into the scheme, I couldn’t be 100% sure what was going to happen, I can now see there’s an agreed roadmap of what’s going to happen, I feel far more comfortable putting money into the scheme on that basis.
So what we find actually is that the strategy setting discussion becomes a forum that actually everybody can give their views in and we find that actually what happens is we frequently set it up, put out scenarios and actually leave the room and let the sponsor and the trustees debate what they're going to get to, and then come back in. So again LDI helps to frame that discussion in a way that everybody understands the risks and is much more happy to take them in the future.
Presenter: Okay, and do you find that sort of companies might say you can have £100 so long as you put it in equities, you know, or I’ll give you £50 if you put it in bonds, but you know they're trying to alter if you like the asset allocation and the various LDI pots it goes into?
Mike Walsh: Clearly there’s not one rule for every pension scheme, every pension scheme is unique, but I think the trend I've seen is the other way around most definitely. As I mentioned, companies want to know the return on their investment, they want to know with a greater deal of certainty if they put the £100 in today; it won't just be put in equities and therefore if equity markets fall they have to come back and put in £200 next year. They want some degree of certainty that ultimately this pension deficit can be managed over the next three, five years, hence it’s actually looking to put it in in a risk controlled way, summing the growth part but in particular making sure you're managing out the interest rate and inflation risk.
Presenter: One thing we keep hearing again in the press is about sort of these so called zombie companies in the UK, they're only keeping going because interest rates are terribly, terribly low, when that changes, you know, we could be in a worse situation for UK PLC certainly in the short-term. Is there a worry there, I'm just wondering how big a worry is that to the pensions industry and in a couple of years’ time, three or four years’ time there might not be some of these corporates able to stand behind their pension scheme? And what can you do if you're worried that you're a pension scheme of a zombie company?
Lucy Barron: So I think pension funds, I mean this is something that they’ve long considered, the employer’s ability to be able to pay into the scheme, what we've referred to a few times as the sponsor covenant. So pension schemes and the trustees have been trying to run the strategy taking into account of the ability of the company to pay in. That’s typically led to more de-risking, schemes putting more money into bonds because they’ve thought that the company may not be able to be there to stand behind if there was a significant fall in equity markets and so on. But clearly those discussions have been taking place for some time, and that’s why the discussion has to be very joint between the sponsor and the trustee to make sure the trustees aren’t making demands that could put the sponsor into more difficulty, but also acknowledging their ability to stand behind the scheme.
Niall O’Sullivan: I think that’s one of the major things that’s changed over the last while is that the discussions have become what we would call actuarially aware. So when we have these discussions, you know, it’s not just investment, an investment problem with investment managers sitting around, typically you have the scheme’s actuary sitting around looking at how he’s handling the contribution rate, you have the people who look at covenant analysis sitting around and saying what the implications of the strategy are. So it gets back to the point that no one size will fit all, and that investment managers who before probably just had the job of picking a good creditor or picking what way rates are going to go, now have to design strategies in the interests of economics, covenant and actuarial considerations.
Presenter: And, Lucy, if we come back to you, we were talking about the importance of having a bespoke solution for a scheme, particularly for a smaller scheme, how do you do that? Because I can see you haven’t got the resources, the ability to bespoke in the same way that a FTSE 100 company has got.
Lucy Barron: So, in terms of LDI, the way that we get around that is by not just having a single pooled fund to, you know, a sort of one size fits all; we have a range of different LDI pooled funds. Such that individual schemes can invest in different proportions, to hedge their five year risk and their 20 year risk and their 30 year risk, all the way up to 50 years in the future, and to allow for their own individual what we call liability profile, the profile of the payments that they're going to make out, how much are inflation linked, how much are fixed in nature, and how they set out into the future.
I think the development we've seen in these funds in the very recent, in recent times is that we've seen those schemes also having the ability to be able to get the most effective and cheapest hedging instrument. I think in the early state of LDI, some of those pooled funds were effectively a buy and hold individual instrument that was designed to hedge a certain risk. I think increasingly we’re seeing much more flexibility. So things that were only open in the past to larger schemes are now accessible to all scheme sizes.
Presenter: Mike.
Mike Walsh: Yeah, no, I definitely agree with Lucy, if I look at our pool fund offering as a range, it started off with just a range of maturity buckets; it’s now over 40 different pool funds. Clearly that could give a governance headache to a client who maybe doesn’t have the ability or the investment consultant to design a solution, hence more and more the investment manager are actually taking those building blocks or pool funds and putting a bespoke solution together for the smaller clients that meets their liabilities, and ultimately meets the liabilities for that specific scheme rather than an average pension scheme, which is very important when you start to really try and manage the risk for each scheme.
Niall O’Sullivan: And I think in a sense we've jumped slightly ahead to the implementation, which is how you, and I think in a sense a lot of people have that cracked, there are a lot of very high quality solutions in terms of delivering these good ideas for smaller schemes. You still have to get though first of all to framing the problem and probably framing it with limited governance, so how do you arrive at what the liability benchmark that we talked about is; how do you monitor that over time; how do you implement the changes when you get the opportunities to implement the changes? Because if you're a trustee group sitting once a quarter, how do you know that you didn’t miss your opportunity intra quarter? So that idea of framing the problem, monitoring it and then being able to act on it becomes very important.
Mike Walsh: Sorry, I definitely agree with Niall and I think it’s really opened the investment consulting market up to some newer individuals to give good quality independent advice on what your investment manager should be designing for your pension scheme.
Presenter: And how do you work out what your liability benchmark, I mean obviously it’s bespoke in each case, Lucy, but I mean is there a danger that somebody, you start to get into meetings and someone says this is your benchmark and everybody accepts it because it’s a figure and it’s nice and quite simple, I mean there must be a lot of knowledge underlying the numbers, can you get everybody up to speed on it?
Lucy Barron: The numbers come from a number of different places, so the starting point is the actuary. We've mentioned the actuary a few times in this. The actuary is coming up with what they think those expected pension payments dating many, many years into the future are going to be. So that’s the first thing, agreeing what those cashflows should look like. Then you need to work out what the right basis is for coming up with the present value of those cashflows. As Niall also mentioned earlier, there’s different interest rates we can use. If the interest rate’s higher or lower we obviously see a different value in that. So they're really the two components: coming up with what the cashflows are; and then agreeing the method or the right interest rate to come up with a value of those.
Presenter: And just going back, Niall, if I may, to this issue about people tend to sit down quarterly, but can you miss the opportunity two months after the meeting, I mean is it difficult to persuade people to give up discretionary power, to allow people to sort of operate the system?
Niall O’Sullivan: I think the key is to understand what it is you're doing. I mean ultimately the decision as to how the money is invested cannot be delegated away; the trustees have to be responsible for the allocations to growth pots, allocation to matching and the overall strategy. What can be delegated away is the implementation and the instruction to it. So you can work with your manager or your consultant to say okay this is where I want to get to, here are the rules of the game, now implement that. What we find is actually it’s quite easy for them to delegate away that responsibility, because it’s that last piece. They're comfortable where the roadmap is going. They will be updated periodically as to what it is; it’ll be recalibrated with new actuarial information on an annual basis. But on the intervening period they say I don’t have to be asked every time somebody wants to buy a bond or sell a fund; it’s something they actually welcome rather than fight.
Presenter: I want to move onto derivatives. We talked a bit about funds for running pension schemes, but I was wondering, is there a danger in derivatives in that it allows you to put a position on quite cheaply, which I could see would be very attractive if you're a little bit short of cash in the pension scheme, but you are effectively borrowing, and is that what you want to do if you're worried about your liabilities?
Mike Walsh: Derivatives in an LDI sense are very much being used for risk control, so I would agree with the point that derivatives are a cheaper way of getting exposure, but we’re not looking to speculate within the pension scheme here; we’re actually looking to manage some of that interest rate and inflation risk or equity risk using equity options, and so we’re actually using the derivative instruments to take out risks from the pension scheme. Clearly, as Niall and both Lucy mentioned, having a framework for what you're trying to achieve and the risk parameters around that means that your manager isn’t just going to go off and do something that you, that surprises you on a quarterly basis; hence the instruments they're using are always to help you meet your end goal of ultimately getting to a fully funded pension scheme.
Lucy Barron: I’d completely agree with Mike’s point in terms of the way that we’re using these instruments is such that if they fall in value, and they can do if you buy an interest rate derivative instrument, it falls in value if interest rates rise, but that’s the situation where your liabilities are falling. So that’s the key thing: you're using it holistically to reduce the risk overall. But focusing on your specific point, are there risks of derivatives? Well there are risks such as counterparty risks, which LDI managers are having to put in place plans in order to diversify the exposures to individual counterparties, to not put all your eggs in one basket, and also where there industry’s got to is the collateralisation process, so the receipt of security such that if you’ve got a position in place with a counterparty and that position has value to you, you receive some security of assets, and you do that on a daily basis using very high quality liquid assets. So there are new risks introduced and new risks to be understood, but there’s ways to manage those risks.
Niall O’Sullivan: I think a critical point is when we say we’re going to borrow, what matters with borrowing is what you do when you buy the asset. The assets, all the derivatives really allow us to do is to accelerate purchases we would otherwise have already made, so you're borrowing to buy assets that match. So back to the point, it’s not speculative in the sense of borrowing to go off and invest in something else that hopefully will dig us out of a hole; it’s borrowing to buy assets that will ultimately match the liabilities.
A second point on the collateral, which I think is very interesting, is the potential move to central clearing and the fact that schemes will have to be ready for that, again is another reason why it’s very important to pick the best managers to implement, because that’s going to be really very complicated. And one of the major challenges is going to be the exchanges are going to demand liquid collateral. Liquid collateral by definition doesn’t yield very much, so it’s going to affect the overall return your pension fund can receive. So therefore you’ve got to think about working with experts who can design strategies to get you your exposure, manage the collateral, but not destroy the returns.
Mike Walsh: I definitely agree with Niall on that. The move to central clearing, although the actual move and the design may be complicated, the ultimate aim is to make it easier for pension schemes and reduce that counterparty risk that Lucy mentioned. Clearly investment managers in this space have been putting in place their plans for central clearing for the past 12 months and are pretty much ready to go once the legislation gets finalised. So from a client perspective it will be a very smooth process to actually centrally clear some of these derivatives, but the important point is ensuring they’ve got enough liquidity or cash like assets within their portfolio. So again that comes back to the investment manager making sure that those conversations are being had with the client about how are we going to raise the cash once the derivative world moves to central clearing?
Niall O’Sullivan: And there are varying degrees of readiness. I mean, in terms of from a consulting point of view, there’s lots of managers who provide LDI, there’s only five that we would rate highly enough to entrust clients’ money with, and all of those things that Mike talked about, Lucy talked about, are part of that rating process, do they know how to do all these things? So it’s very important to look under the bonnet of what your manager’s going to do for you before you entrust them with your money.
Presenter: And in this world of more and more experts, I mean in a sense is there a danger you all start to eat each other’s lunch? I mean everybody seems to be having more expertise around investments, derivatives, to what point do you complement each other, to which point are you competing as managers?
Mike Walsh: I think as fund managers clearly the client base is the same, but this is still a young and growing area, LDI, so it’s a very big market. I think we’re all, the good thing is we’re all working towards the end goal, which is to help pension schemes manage their risks, whether it be via investment consultants or fund managers, so in that aspect we’re all pulling in the same direction. Clearly, as I mentioned earlier, things like inflation supply is limited, and therefore the managers that can get access to that inflation are in a better position to help their clients than perhaps other managers who don’t have the same presence in the inflation market.
Presenter: We've been talking a lot about LDI in the UK, but are there any interesting developments in some of the other sophisticated pensions markets, the United States, Holland? Anything that’s on the horizon there that could be, is either a danger sign for us here in the UK or something we could use?
Lucy Barron: I don’t think it’s necessarily a danger sign, but there’s obviously been big developments in both the US and Holland recently. The US one being, well both effectively are moving in the same direction, which is interest rates are extremely low, this is pushing up the deficits in pension schemes, reducing funding levels and increasing the amount that sponsors are therefore having to pay into those schemes. And what we've seen, I mean it’s been approached in a slightly different way in the US and the Netherlands, but what we've seen is a move where there’s been a move away from a pure market implied interest rate to an interest rate that’s slightly higher, either by looking at this longer historic period, or setting a higher rate that should be used, that’s had the impact of boosting the funding position in those schemes.
It’s obviously something that has been looked at in the UK, there’s been various comments on, but to date, where we’re using more of a flexible repayment of deficit period, rather than adjusting implied interest rates, we’re just using the market rate as the market rate at this stage.
Presenter: Okay.
Mike Walsh: No, I’d agree with Lucy. I think it’s quite interesting, the Dutch market was an earlier mover into the world of LDI and now many of their pension schemes have used these instruments for longer than UK pension schemes. But in LDI, in particular, the UK market is further advanced than the US market, and we’re finding the US market is quickly leveraging off the skill of the UK market. We've now built a large business, LDI business in the US, based on the expertise from the UK market. So it’s quite nice for a change that the UK is leading the US in investment matters.
Presenter: Okay, a great British export. Niall, anything to add?
Niall O’Sullivan: No, I think the Dutch experience is an interesting one because if the Solvency II stuff we talked about earlier on, making pension funds invest like an insurer, happens, that’s already almost the Dutch context of how they're handling things. So therefore it’ll be a case of taking with one hand and giving with the other, because on the one hand it’ll force people to be much more liability aware and invest much closer to them, but the second side, back to Lucy’s point, it’s the very long end of the curve where they're effectively forcing what they're calling an ultimate fare forward rate. So they're going to ignore to an extent what market rates are beyond about the third year point and say well they should be here and that’s how we’ll value the liabilities.
At the extreme margin, if that was to happen, it might mean that very long dated gilts and index linked gilts could potentially have a few less buyers than they had before, but we’re a very long way away from that and most of the schemes that we deal with would also be a very long way away from being that fully hedged, that that would be an issue.
Presenter: Right, well we have to leave it there. Niall O’Sullivan, Lucy Barron, Mike Walsh, thank you very much. Thank you for watching, and from all of us here at Asset.tv, goodbye for now.
Information and opinions contained in this interview have been arrived at by AXA Investment Managers. AXA Investment Managers and Asset.tv Ltd. accept no liability for any loss arising from the use here of nor make any representation as to their accuracy or completeness.
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Any underlying research of analysis has been procured by Mercer for its own purposes and may have been acted on by Mercer or an associate for its or their own purposes. Mercer is authorised and regulated by the Financial Services Authority.
Information and opinions contained in this interview have been arrived at by Legal & General Investment Management. Legal & General Investment Management and Asset.tv Ltd. accept no liability for any loss arising from the use here of nor make any representation as to their accuracy or completeness.
Any underlying research of analysis has been procured by Legal & General Investment Management for its own purposes and may have been acted on by Legal & General Investment Management or an associate for its or their own purposes. Legal & General Investment Management is authorised and regulated by the Financial Services Authority.
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