Aaron Meder, head of investment at Legal & General Investment Management, discusses the future of liability driven investment as pension schemes reach their endgame

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Legal and General

When it considers the primary objective to ensure that members’ pensions are paid in full and on time, every defined benefit pension scheme eventually needs to think about its endgame.

The endgame is likely to take one of two forms, as specified by over 90% of respondents to the Legal & General de-risking survey:

• Buyout: Pay an insurance company to take on scheme liabilities and pay benefits (11%)

• Self-sufficiency: Manage the scheme’s assets to produce the required cashflows to pay benefits, which may include investment in longevity insurance or an insurance buy-in (81%)

We expect the preference for self-sufficiency investment strategies to continue for the foreseeable future, but as schemes mature and funding levels improve, the focus on buyouts is likely to increase. Ultimately, for all schemes, there will be a point where it is cheaper to buyout the scheme than to continue to manage it on a self-sufficiency basis.

Corporate bonds are going to be more important that you think

Whether the endgame is buyout or self-sufficiency, we believe that pension schemes will seek to achieve their endgame by investing in a low risk manner similar to how insurers invest to back pension annuities. As with insurers, at the heart of this will be a significant allocation to cashflow-oriented investments, in particular corporate bonds.

For schemes targeting buyout, the corporate bond allocation aims to deliver returns in excess of the buyout liabilities, match changes in buyout pricing and be cost efficient to liquidate or transfer to the insurance company at buyout.

We estimate that an ‘average’ scheme would need to invest approximately two thirds of its assets in corporate bonds to match the corporate bond sensitivity of pensioner buyout prices. In order to track buyout pricing most efficiently, the size and composition of the corporate bond component should be dynamically managed based on both market and insurance specific factors.

For all schemes there will be a point where it is cheaper to buy out the scheme than to continue to manage it on a self-sufficiency basis”

For schemes targeting self-sufficiency, the focus will be on bond investments which deliver cashflows at the right times to pay pensions as they fall due. Some clients will seek further risk reduction through longevity insurance or buy-in transactions.

Currently, the average self-sufficiency target amongst our clients of gilts plus 0.5% suggests that they expect to have more than half of their assets invested in corporate bonds once they reach full funding (assuming that corporate bonds generate a yield of approximately 1% over gilts).

Risk Reward

As a consequence, we believe that LDI strategies will evolve to reflect a more holistic investment strategy where corporate bonds, government bonds, swaps and any other ‘matching’ assets are managed together against a distinct liability benchmark, to generate a return in excess of this benchmark, minimise costs, and pay pensions.

We are seeing increased demand from our clients to manage their ‘matching’ assets to deliver such long term endgame objectives.

Increasingly, our clients are expanding their LDI mandates to include corporate bond portfolios with relatively low turnover, designed to pay pensions as they fall due. In addition, we are increasingly focused on identifying market opportunities to generate excess returns by actively managing the allocation between corporate bonds, government bonds and swap-based LDI investments within a self sufficiency strategy.

Attention will turn to illiquid assets as a source of long-term returns

Increasing interest in illiquid investments (with 28% of respondents citing illiquid investments as the main growth area for investment over the next ten years) is no surprise given their potential to generate excess returns and help pay pensions. They are very long term, can be bond-like in nature and potentially provide an ‘illiquidity’ premium above gilts.

However, illiquid assets are, by their nature, difficult to value or sell. This can present problems in terms of assessing a scheme’s funding level or if the assets need to be realised to pay pensions.

In addition, schemes will need to factor in the ability (or not) to transfer such illiquid assets to an insurance provider at buyout.

Liability benchmarks will include a corporate bond based discount rate and become more precise.

In this new world, the definition of success will no longer be “I’m 100% funded, but with an acceptable level of risk”

We expect liability benchmarks to evolve from a simple ‘gilts plus x%’ basis, to a basis where the liabilities are discounted based on the expected return of the assets (and therefore corporate bond-based discount rates). This will mean valuing the funding position in a similar way to the way that insurance companies consider their  assets (after expected defaults and expenses) expected to be sufficient to pay benefits?

In addition, the closer to a fully funded position and full matched position that a scheme gets, the more important it is that the estimated cashflows are correct.

Consequently, we expect to see closer collaboration and information sharing between actuaries, administrators and investment managers to define cashflow requirements and the liability benchmark so that the assets can be managed to reflect changes in the membership profile, liability assumptions and market conditions.

Conclusion

Over the next ten years LDI will move away from its historic focus on reducing funding level volatility by matching asset and liability sensitivities to interest rates and inflation.

Instead the focus will move to matching cashflows through holistic management of a range of bond-like assets (including corporate bonds and illiquids) to minimise risk, generate excess returns and ultimately, pay pensions in full.

In this new world, the definition of success will no longer be “I’m 100% funded, but with an acceptable level of risk”, but will move to a more practical assessment: “I’m solvent, I expect that interest and principal receipts from my assets to be enough to pay benefits as they fall due with an acceptable level of probability”.

Aaron Meder, head of investment, Legal & General Investment Management