Forget Peak Oil, This is Peak LDI
LDI has been a wonderful addition to the global institutional investment world. Using bonds to match cashflows (mirroring the actuarial assumptions on which pension scheme liabilities are based) and derivatives to hedge interest rate risk. By using LDI, pension schemes have been able to ensure their assets and thus funding levels by and large mirror their liabilities.
However, years of low rates, means that LDI can’t deliver the investment returns that schemes need. Investment specialists talk about using LDI in the matching portfolio and then having a growth portfolio. Surely this is destined to be an unhappy compromise? At best such an allocation provides matching for only 50% of the liabilities, yet seeks to generate a return for the entire portfolio by only putting 50% of it to work, We have neither 100% removed the investment risk, nor have 100% tried to close the funding gap.
Perhaps ironically, it could be The Pension Regulator that really brings about the end of LDI’s dominance. How? Through Integrated Risk Management or IRM. Looking at holistic pension scheme risk. Best viewed as a triangle with three interrelated angles of corporate sponsor, investment and funding. Whilst most consultants are keen to talk to their clients about IRM, only a minority seem to really think holistically about pension scheme risk. So how does IRM impact on LDI? For well funded schemes, low-risk liability matching investment seems to make a lot of sense. For poorly funded schemes, there are only two ways to plug the deficit, either rely on investment returns, or corporate contributions.
Whilst LDI certainly reduces investment risk, is there not an argument that for a poorly funded scheme, the adoption of LDI (and de-risking in general) reduces investment risk only to increase covenant risk? If the assets are no longer being relied on to generate return, then the pressure on mummy and daddy (AKA the corporate sponsor) increases. This may be an even less desirable part of the IRM triangle to assign risk, as a corporate sponsor (unlike an investment portfolio) is typically non-diversified and rather binary. It will either be in business, or bankrupt. Whilst a well diversified growth-oriented portfolio is highly unlikely to lose 100 percent of its value, a struggling corporate entity faced with ever increasing cash calls can (as we have seen in 2018) very easily go to the wall.
The growth of multi-asset, sophistication in the use of derivatives to hedge risks and mirror liabilities, the growth of private debt and innovations in IRM all seem to be contributing to what we might one day call Peak LDI. Whether its 2019 or a couple of years later, my hunch is that LDI, whilst always having a place, is enjoying its peak right around now.
To ensure you have the very best LDI talent, or to discuss the concept of peak LDI and the future direction of travel, please get in touch with Plenum.