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Investment Surgery

Investment surgery

Why does Liability Driven Investment (LDI) seek to do?

Although Liability Driven Investment (LDI) has become a hackneyed term, quite simply it’s an exercise in risk management. Given that the principal aim of any defined benefit (DB) pension scheme is to meet its liabilities as they fall due, for those schemes in deficit LDI provides a means of potentially preventing the deficit from deteriorating further and ultimately eliminating it. This LDI does by focusing on the mitigation of those so-called unrewarded risks, such as interest rate, inflation and longevity risk, that can cause scheme liabilities to outpace assets and deficits to widen. However, it also seeks to capture a diversity of those potentially rewarded risks - which derive from having a market exposure to risk assets such as equities and credit - that ultimately contribute to the achievement of the scheme’s long term funding plan.

Does this imply that DB scheme deficits are largely a failure of risk management?

Yes. Therefore, the imperative is for trustees (with a little help from their investment and/or de-risking consultant) to identify and manage the many and various risks that reside on both the asset and liability side of the pension scheme balance sheet. However, as risk and return isn’t always two sides of the same coin, in that whilst some risks are potentially rewarded and others aren’t, it makes intuitive sense for trustees to not only have an understanding of the contribution that each of these risks makes to their scheme’s overall risk exposure, but also to be able to test the effect of removing individual risks to ensure the probability of achieving their long term funding plan isn’t compromised. Unfortunately, as risk is one word but not one number, there is no single approach to mapping and measuring risk. Therefore, LDI views and manages the many and various risks, that reside on both the asset and liability side of the pension scheme balance sheet, through multiple risk measures, or risk “lenses”. Of course, the ultimate objective is to minimise the unrewarded risks whilst taking a diversified approach to assuming potentially rewarded risks, subject to the constraints of a defined “risk budget”.

So what are the key risk measures, or risk lenses?

Although by no means an exhaustive list, the three most commonly used risk measures for the purposes of implementing an LDI programme are Value at Risk (VaR), PV01 and scenario testing.

What do these risk measures tell us?

1. Value at Risk (VaR)
Typically VaR is measured at the 95% “confidence level”. A scheme’s “95% VaR” is the percentage or absolute monetary amount by which a scheme’s deficit, based on historic data, may widen during the course of the next 12 months if it were to be hit by a “1 in 20” event. That is, an event that statistically the scheme shouldn’t experience on more than 5% of occasions, or one year in every 20. This is where the notion of a "risk budget" comes in. For instance, the 95% VaR calculation may reveal that “there is a 5% chance the deficit could increase by 25% over the next 12 months.” This VaR number can be decomposed into the individual contribution of each source of unrewarded risk and that which is potentially rewarded. For many schemes, as the unrewarded risk can far outweigh potentially rewarded risk, mitigating the former may either free up some of the scheme’s risk budget for an increased diversified exposure to risk assets or simply bring the VaR – the risk budget - down to a more palatable number.

2. PV01
PV01 measures the impact of a 1/100th of 1% (0.01%), or 1 basis point, change in market expectations for interest rates and inflation, respectively, on the value of the scheme’s liabilities. For example, for a large scheme with £5bn of liabilities, PV01s of around £10m to £15m are not uncommon. That is, should interest rate expectations fall by a meagre 0.01%, then the liabilities will rise by a not inconsiderable £10m/£15m. Similarly, if inflation expectations rise by a mere 1 basis point, then the liabilities will rise by a similar magnitude. This PV01 can be decomposed into “risk buckets” that analyse the impact of a 1 basis point change in interest rates and/or inflation expectations at discrete points on the scheme liabilities’ maturity spectrum. In the same way that instruments such as swaps and/or bonds are used to reduce the scheme’s VaR, they are also used to reduce the sensitivity of the liabilities to changes in interest rates and inflation and, more recently, longevity.

3. Scenario testing
Scenario testing takes account of the fact that the world is subject to more random events and highly damaging risks, many of which are unforseen, than statistical theory and risk models, such as VaR, predict. Therefore, the scheme's assets and liabilities should be stress tested against a range of past and possible future scenarios to gauge the scheme’s robustness to whatever the world has to throw at it. However, whilst a range of, typically derivative-based, methodologies can be employed to reduce these outliers, “Black Swans” or "tail risks", by definition the sheer number of “unknown unknowns” can never be fully captured in risk models.

How are unrewarded risks mitigated?

Unrewarded interest rate and/or inflation risks can be hedged, or mitigated, through the use of instruments such as interest rate and inflation swaps and conventional and index-linked bonds of an appropriate “duration”. Each instrument has its own merits. In so doing, the adverse impact of falling interest rates and/or rising inflation on the scheme’s liabilities will be offset by the swaps and/or bonds held, so preventing the scheme deficit from widening. In addition, longevity risk, arising from increased scheme member life expectancy, can now be hedged by longevity swaps.

What are the practicalities and challenges of implementing an LDI policy?

Only once all the quantifiable risks have been mapped and measured and the risk budgeting decision has been made can an LDI programme be implemented. Unfortunately, this is not a simple process, not least because the tools used to mitigate unrewarded risks, such as future movements in inflation and/or interest rates, for example, with particular reference to instruments such as swaps and bonds, are not always available at the required sizes and prices. Indeed, trustees will need to draw on the considerable expertise of a de-risking specialist and a LDI asset manager: the former for their investment banking expertise and established network of banking contacts and the latter for their strong negotiating position in the swaps market and extensive credentials in the active trading of interest rate and inflation swaps. Moreover, the heightened investment governance required to oversee the LDI process may also result in the trustees delegating to an LDI sub-committee, with the requisite time and expertise to ensure a successful outcome. This, in turn, necessitates gaining the support of the sponsor as well as meeting regularly and working closely with the de-risking specialist and LDI asset manager in:

• setting up a panel of competing investment banks with whom they may potentially transact swaps;
• outlining the trading etiquette to these banks, making clear the penalties of non-compliance;
• setting up the necessary infrastructure, or ISDA agreements, between the scheme and the chosen counterparty banks;
• gaining prioritised access to swap supply;
• obtaining the best possible prices and minimising transaction costs;
• continually tracking progress in reducing the scheme’s unrewarded risk;
• overseeing the collateralisation process, and
• actively managing the swaps and/or bonds as market conditions change.

In short, to be successful, an LDI strategy is one that is highly dependent on a strong five-way partnership between the trustees, sponsor, investment/de-risking consultant, asset manager and the investment banks.

Resource centre

Download relevant articles, reports and news items:

	Investment Surgery: Liability Driven Investment Chris Wagstaff looks at the rationale for and methodology behind Liability Driven Investment. Aviva Investors/Engaged Investor
	Investment Surgery: Reducing Scheme Risks Chris Wagstaff examines the details of reducing scheme risks. Aviva Investors/Engaged Investor
	Defined contribution: Improving the outcome for the default investor Closure of defined benefit (DB) pension provision and its replacement with defined contribution (DC) has not only shifted the risks of saving for retirement firmly from employers to employees, but also requires DC investors to make decisions about the asset allocation and timing of their investments. The Investors Journal. | 10/122/150311
	Pensions Insight - Timing your swaps In June 2008, after having conducted an analysis of the scheme's risks, the Aviva Staff Pension Scheme Trustee Board decided to implement a de-risking programme that would reduce the sensitivity of funding levels to changes in interest rates and inflation. This article looks at the innovative approach adopted. Pensions Insight | September 2009