Is the shift towards liability-driven investment (LDI) fundamentally flawed as a concept and appallingly timed in its execution? The posing of that question to a number of industry participants sparked a broad range of reactions, some positive, some negative, some supportive of the thesis, others dismissive, even hostile. Brian Bollen reports.

Hitting The Nail On The Head

The principal findings of this LDI mini-survey are not universal. Broadly speaking, there is agreement that the first part of the proposition is wrong, while the second part hits the nail on the head. Paul Bourdon, Director of Investment Solutions at Threadneedle Investments, disagrees with both premises. "Pension funds have an obligation to produce a portfolio that delivers the pension liabilities it must meet," he summarises simply. "Any portfolio constructed without due regard for that basic truth is fundamentally flawed."

Everything, it seems, hinges on definition. Define LDI accurately, and everything falls into place. Misconstrue LDI as being nothing more than the herd-like rush by UK pension funds out of equities and into overpriced bonds, and you will be left forever stumbling around in a fog of ignorance. "The investment industry is awash with terms that have one pure meaning, like LDI, and hedge funds, that have been hijacked by marketers to sell different products, " comments Ralph Frank, a principal at Mercer Investment Consulting.

"LDI is about more than just matching liabilities. It's about construction of the portfolio, and it's about the financing of the scheme," says Paul Bourdon. "It's about managing the liability using bonds or derivatives and then creating a risk-return portfolio that delivers the return you are looking for. Managing the risk inherent in a long-term pension liability on the basis of rolling five-year periods in the equity markets exposes you to huge risk. LDI is a process, a framework, which makes you understand the risk to which you're exposed. Once you know and understand the risk you can attempt to manage the risk. This is not a good time to invest in bonds, but it doesn't mean you shouldn't hedge bonds.If you use bonds to hedge your liabilities your assets will be marked to market and your deficit will rise, yes, but if you use derivatives the value of the derivatives will move in an equal and opposite direction."

The attractions of other forms of investment than bonds in the current market climate are legion, and self-evident, if one places any credence in opinions from the front line. Peter Kaye, manager of the Melchior North American Opportunities Fund, for example, is bullish about US equities. There would appear to be a disconnect between the fundamentals in the USA, which have been and remain excellent, and an equity market which has failed to make much headway for two years, he continues. Today, corporate America is in what he describes as fabulous shape after three years of very robust double digit earnings growth, he observes. "Cashflow is at record highs for companies and balance sheets have never been stronger," he argues. "The result of this disconnect is a market that is trading on a 10-year low in terms of forward price earnings multiple. The major factor which would seem to have caused this disconnect is the risk of inflation and therefore the duration of the current interest rate cycle. However, core inflation data has been subdued, long-dated bond yields remain low and there is little evidence of significant pricing power at the corporate level. After 14 tightening moves in US interest rates, all indicators would seem to point to an end in the rate cycle in coming months and in the near future US equities are likely to switch out of small to mid cap companies in favour of larger companies."

To invest without understanding your liabilities is bad investment practice, tantamount to speculation, argues Ashok Shah, chief investment officer at London and Capital. "The need for assets to match liabilities requires an understanding of the liability pattern stretching over a period perhaps longer than 50 years. In the past this liability pattern has been sadly lacking. Investment mandates were defined in term of managing assets without a direct link to the liability pattern. Hence one could have ended up with assets very unsuitable for the liabilities. The objective of LDI is that the volatility of the assets matches the volatility of the liabilities. However, many drivers of the liabilities - such as improvements in mortality rates - cannot be easily matched."

Daniele Paglia, Zurich-based senior portfolio manager, fixed income, at Credit Suisse Asset Management, questions whether investors should be investing in low-yielding bonds. "But what is the alternative?" he then asks. "If you do nothing, you are implicitly taking a bet on interest rates. You're allocating a huge part of your risk budget to interest rates. LDI is only a useful framework to help you move from an asset-based benchmark to a liability-based benchmark."

Don't Panic! Don't Panic!!
Despite recent extensive coverage of the switch from equities to bonds, the reported panic has been overstated according to the preliminary results of a of a new survey by Mercer Investment Consulting. "Despite wide-spread speculation that pension schemes are increasing their investment in bonds, the average allocation remains the same as last year, at 35%," Mercer reports. The survey of over 425 UK defined benefit pension schemes with more than £177bn in assets shows that the average allocation to bonds has increased by just four percentage points in the last three years. At the same time, pension funds are maturing and the proportion of schemes open to new entrants has fallen to 39% from 42% last year. The survey also shows that the average allocation to equities has dropped only slightly ­ from 63% in 2005 to 62% this year. Investment in UK equities has fallen from 37% in 2005 to 35% this year, while allocations to overseas equities have risen by one percentage point to 27%.

"Pension funds still have far too high an exposure to equities and very low exposure to higher income producing assets," adds Ashok Shah. "As the regulators have effectively forced pension funds into matching assets and liabilities, there is a market imbalance, in that there is a lack of supply of the required bonds. This shortage may have led to prices rising so that current holders are tempted to sell or new supply can come through. This transition from unmatched to matched positions will continue to create market distortion. The market place will provide the solutions. Rising M&A activity is just such a response. Effectively equity is being replaced by debt; this is exactly what the pension funds want, and are paying a lot to agents facilitating this transition."

"LDI is nothing new," comments Euan Munro, head of strategic solutions at Standard Life Investments, which in recent memory was instructed by the Standard Life Assurance Company to switch a large amount of that company's portfolio out of equities and into bonds. "Pension funds have been doing it for decades. What IS new is the requirement by accounting standards and regulators to mark assets to market in response to short-term price movements. What is flawed is to invest in such a way as to meet exactly current estimates of what the liabilities will be; those liabilities are themselves estimates based on a number of assumptions that could certainly be questioned. We believe that pension funds should remain invested in equities and other risky assets to the extent they can afford to in line with their total risk budget.

"You don't need to buy bonds to get interest rate exposure; you can use derivatives," he continues. "If you keep your money in equities but enter into a 30-year swap, you get a 30-year fixed rate and agree to pay floating rate Libor. It's worth nothing at first, but if interest rates fall, it goes into the money, and becomes a profitable asset, you make money. If interest rates rise, the swap is making a loss but your liabilities fall as well. Some investors have reservations, but this approach massively reduces pension fund risk relative to liabilities."

In the end, Paul Bourdon argues, like it or not, the industry is changing, and the future will bring even more of a focus on LDI, and it is the investor in the street who will pay for it. "Corporates have reduced their investment risk exposure, and their own costs, by cutting the amounts they will pay into defined contribution schemes."

But what will be the long-term impact of this dissolution of one of the few remaining pieces of glue binding employee to employer? There are clear indications that companies who shut down their defined benefit schemes will find it harder to retain quality staff, and even harder to recruit them. Indeed, more than one of the interviewees for this article highlighted the attraction of the defined benefit system in their own career thinking.

There is arguably a deeper warning for pension funds and asset managers as a small number of future pensioners turn their back on the industry. If the fad becomes a trend which then becomes the dominant form of investment, fund managers face an uncertain long-term future. "We're seeing the face of pension planning changing in front of our eyes, at least for the affluent, and the industry doesn't realise it," concludes Jeff Trewella, managing partner of Pennsylvania-based Tanglewood Capital Partners.