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LDI
ESSENTIAL
GUIDE
ESSENTIAL
GUIDE
THE
BACKESSENTIALS
TO BASICS OF
LIABILITY DRIVEN
INVESTMENT
Contents
17
37
Executive summary
In this guide for institutional investors,
we provide an introduction to liability
driven investment (LDI). Our aim is
to help investors build a base from
which they can develop a deeper
understanding of this approach to
investment, as well as encourage them
to consider what LDI could mean for
their schemes investmentstrategy.
Prepared by BlackRock
insights@blackrock.com
blackrock.co.uk
Understanding
the liabilities
1,000
1.04 x 1.04 x 1.04 x 1.04 x 1.04
1,000
(1.04)
821.93
@ 4%
1,000
800
1,000
@ 6%
822
@ 9%
747
650
600
400
200
0
Time
5 years time
Value today
5 years time
1IAS 19 is the set of accounting rules for employee benefits set out by the International Accounting Standards Board.
These define how pension liabilities should be measured within a companys annual accounts.
Aged 45
Salary 18,000 per annum
10 years of service
1/60th scheme
Accrued pension of 10/60 of salary (3,000)
What do the projected benefits look like? The actuary would make a number of
assumptions regarding longevity, wage inflation, price inflation etc. Figure 2 shows three
components of the future benefits:
The dark blue bars show the benefit already accrued (10/60 of salary or 3,000
perannum)
The light blue bars show the projected additional pension payments per annum
stemming from wage inflation between now and retirement (weve assumed a 6,000
salary increase between now and retirement increasing the pension by 1,000)
The grey bars show the impact of price inflation once the pension is in payment as it
will be increased in line with inflation (often subject to a minimum floor of 0% a year
and a maximum cap of 5%)
Time
Price inflation
Wage inflation
Accrued benefit
In general, the actuary will not take account of future service. The objective of the
valuation is to decide how much should be set aside today for benefits that have been
accrued to date2.
The next step is to calculate a present value for the members future payments. Each
years expected payment is brought back to a present value (the time value of money
again) and the total represents how much should be set aside for a particular member.
8,000
6,000
4,000
2,000
0
Time
Age 45 (Now)
Price inflation
Wage inflation
Accrued benefit
2There is a distinction between what is often called the Accrued Benefit Obligation (ABO) and the Projected Benefit
Obligation (PBO). The main difference is that the latter will include allowance for future salary increases, the former
assumes that salary is unchanged until retirement. The ABO will give a lower value to the liabilities than the PBO.
A full valuation will do this for every member and the aggregate value is the pension
funds total liability. This is often compared to the market value of assets to arrive at the
funding level.
Funding level
()
Time
2010
2020
2030
2040
2050
2060
2070
2080
Expected cashflow ()
As can be seen, the expected cashflows often rise steadily from current levels before
tapering away as current members retire (if they havent done so already), draw pensions
and eventually die.
We can split the aggregate cashflows into those we are expecting to pay to existing
pensioners and those payable to active and deferred members. Over time, defined
benefit schemes have closed to new members and, in some cases, to the accrual of new
benefits. Consequently, most pension funds have a small and declining pool of liabilities
in respect of active members.
In figure 5, the grey shaded area on the left is the proportion of cashflows payable to
pensioners and the light green shaded area on the right is the liability ascribed to active
and deferred members.
Expected cashflow ()
Actives/deferreds
Liability sensitivities
Liability cashflows are based upon the benefits to be paid from a pension fund. They can
be split between those payments that are linked to inflation and those that are fixed.
A fixed payment is where a pensioner receives a proportion of final salary at retirement
with no future increases. An index-linked pension usually delivers payments with annual
increases linked to inflation. This latter form of benefits represents the majority
of pension fund liabilities for many UK schemes.
3Caps and floors vary depending on the benefits of a particular fund. Many pension funds will have some liabilities which
are capped at 3%, often expressed as LPI (0%, 3%). New liabilities accruing are often capped at 2.5% i.e. LPI (0%, 2.5%).
Expected cashflow ()
Year
2015
2020
2030
2040
2050
Inflation (LPI)
2060
2070
Inflation (RPI)
2080
Fixed
These sensitivities are very important, as we shall discover later. The extent to which the
liabilities are sensitive to inflation should be considered when investing the schemes
assets. In order to manage the risk from inflation being higher than expected, it makes
sense to have assets that also reflect that sensitivity.
4 The relationship is more accurately stated as (1 + nominal interest rate) = (1 + inflation) x (1 + real interest rate).
Therefore, the return generated by placing money in an investment with a given interest
rate includes a component to keep pace with inflation plus the real interest rate which
reflects real (after inflation) growth in the investment.
For example, a high street bank might quote a 4.6% fixed rate of interest for a oneyear investment. An investor who puts in 100 will therefore get back 104.60 at the
end of the year. If inflation is expected to be 3.0%, then the real interest rate is 1.6%
(4.6% 3.0%). The real interest rate reflects the growth in the purchasing power of
the 100 investment.
10
Time
10
Inflation
100
The next question to ask is how much should we set aside today to meet the future
payment i.e. what is the present value of the future liability? In this case we will use
the interest rate of 4% to estimate the present value (made up of 3% inflation and 1%
real interest rate as above). Figure 8 overleaf shows how the present value of 90.53
is derived.
()
90.53
Present value = 100 x 1.03
10
10
= 90.53
10
1.01 x 1.03
Time
10
Present value
Inflation
100
100 x 1.0310
1.0410
~
~
100 x 1.0310
1.0110 x 1.0310
What we can see is that the inflation term is on the top and the bottom (the 1.0310) and
these actually cancel out.
In fact, the 90.53 can be arrived at just by knowing the real interest rate (100/1.0110 =
90.53).
While the reality is more complicated than presented here, the message is that for the
majority of pension schemes liabilities, the value of these liabilities is very sensitive to
changes in real interest rates.
5The nominal interest rate of 4% is comprised of inflation and the real interest rate. We have made a minor simplification
in that if inflation is 3% and the real interest rate 1%, then the nominal interest rate is 1.01 x 1.03 = 1.0403 = 4.03%,
rather than 4%.
FIGURE 9.
PERCEPTION
(%)
REALITY
(%)
Time
Assets
Time
Assets
Liabilities
Time
Liabilities
Valuation
Time
Expected cashflow ()
Time
Swaps?
Buyout?
2010
2020
2030
2040
2050
2060
2070
2080
Expected cashflow ()
Pension Protection Fund (PPF) this is often called a Section 179 valuation.
It values a pension funds liabilities assuming it enters the PPF, so there are caps
on pensions and other restrictions reflecting the benefits the PPF would pay.
The discount rate for the liabilities is based on gilts.
S
waps liability cashflows can be valued using swap rates. Generally, this type of
valuation is very useful when setting investment strategy, since swap rates provide
an investable rate for every future point in time. Swap discounting is widely used for
investment purposes.
Buyout this reflects the value an insurance company would put on the liabilities
if the trustees wanted to transfer the liability to the insurance company. Historically,
actuaries have used assumptions to estimate what the buyout cost might be.
However, as the buyout market has become more active, it has become more difficult
to estimate this cost. Buyout prices have changed dramatically depending on the
desire of insurance companies to do this type of business. Some buyout companies
give guidance or a formula for what the indicative buyout cost would be, but often
it is possible to get a precise valuation only when a quote is provided.
Interest rate
and inflation swaps
UNDERSTANDING SWAPS
Derivatives, particularly interest rate and inflation-linked swaps, are increasingly in
demand to help pension funds effectively manage their risks and returns.
In the UK, a strong two-way market in inflation-linked swaps has developed, although
this market is typically less liquid than the interest rate swap market.
The growth of the interest rate and inflation swap markets has been partly driven by
the limitations of gilts. In particular, index-linked gilts cannot be combined to accurately
match liabilities, do not offer protection against deflation and expose a fund to
reinvestment risks.
As explained previously, pension fund liabilities are often linked not just to inflation,
but to inflation with a cap at 5% and a floor at 0%. This has established demand for
Limited Price Indexation (LPI) swaps, with embedded caps and floors.
Introduction to swaps
Swaps are a potent tool for pension funds as they offer the ability to transfer risks
to other parties. The proportion of pension funds that have entered into swap
arrangements has grown rapidly. Over the next few years we expect this growth to
continue as more trustee boards become comfortable with these more sophisticated
risk management tools.
What is a swap?
A swap is an agreement between two parties (one usually being an investment bank)
to swap one stream of payments for another. Swaps are individually tailored contracts
(sometimes referred to as OTC or over the counter) and can be based on any terms
agreed by the two parties.
Swaps based upon interest rates and currencies have existed for over 30 years. An evergrowing list of instruments is now being included such as inflation, credit, equity market
returns and commodities.
Swaps generally involve an exchange of a fixed set of cashflows, known in advance, for a
variable (floating) set of cashflows that depends on the future path of some variable.
Figure 11 shows a simple example of a swap. On the left we have one party willing to
swap fixed cashflows based on 5% of a particular amount, say 100. These cashflows
are exchanged for payments based on a floating interest rate applied to the same
amount. Based on expectations about future interest rates, these are expected to
be 4, 6 and 5.
Fixed cashflows
Floating cashflows
6
5
SWAP
2
0
Time
Year 1
Year 2
Year 3
Year 1
Fixed
Year 2
Year 3
Floating
Some terminology
The four most important things to know about a swap are the term, the notional
principal, the fixed leg and the floating leg.
Fixed leg
Can be based on just about anything
where there is a future expectation
Fixed leg
x
Pay
fixed
x
Pay
floating
z
Floating leg
Notional principal
Payments are based on this amount,
although it does not change hands
Floating leg
Usually a cash rate called LIBOR
(London Inter-Bank Offer Rate)
An important rule
An integral part of any swap is that, at the outset, the present value of each future
stream of cashflows is equal. This means that the expected fixed and floating cashflows
have an equal present value you would not enter into a swap where one side was worth
more than the other.
After the swap has begun, the fixed payments will not change, while the floating
payments will fluctuate with actual interest rates. Thus, one party will gain at the
expense of the other as interest rates change.
Pension funds usually use swaps to hedge (reduce) risk. As we shall see, although a
pension fund may make a loss on a swap, this is usually balanced by a reduction in the
liabilities. Similarly, a gain on a swap will often be offset by a rise in the liabilities.
3
Pension
fund
3
3
Counter
party
4
2
In this example, the pension fund would pay 3 each year to the counterparty. In return,
the actual inflation rate each year would be multiplied by 100 to calculate the payment
to the pension fund. We have assumed actual inflation turns out to be 3%, then 4% for 3
years before falling to 2%.
Therefore, the pension fund has exposure to actual inflation over the period.
For the preceding example there are three possible outcomes:
Inflation = expectations
Inflation is higher than expectations
Inflation is lower than expectations
These are shown in figure 14.
3 3 3 3 3
3 3 3 3 3
3 3 3 3 3
Pension
fund
Counter
party
3 3 3 3 3
Pension
fund
4 4 4
5 Counter
party
Pension
fund
Counter
party
3
2 2 2 2
Clearly, if inflation meets expectations, then neither party gains nor loses.
If inflation is higher than expectations (more than 3%) then the pension fund will gain on
the swap. However, when inflation increases, the future liabilities will also increase, so
the gain on the swap is offset by a rise in liabilities. Risk has been reduced.
If inflation is lower than expectations (less than 3%) then the pension fund will make a
loss on the swap. However, when inflation decreases, the liabilities will also decrease, so
the loss on the swap is offset by a fall in liabilities. Again, risk has been reduced.
Liabilities
Pension
fund
pay
receive
Counter
party
Investment banks
source inflation from
utility companies,
supermarkets,
Private Finance
Initiatives etc.
Investment banks have been effective in sourcing inflation (i.e. finding entities that wish
to pay inflation and receive a fixed rate). This is the opposite of what a pension fund
needs, so the whole arrangement is mutually beneficial.
A utility company with revenue linked to inflation but financed through fixed rate loans
or debt will often want to pay inflation and receive a fixed rate as this will reduce its risk.
Types of swap
Pension funds generally enter into two types of swap inflation swaps and interest
rate swaps.
Pension
fund
pay fixed
Counter
party
receive inflation
Pension
fund
pay floating
Counter
party
receive fixed
Swap cashflows
The cashflows of a swap usually take one of two forms:
1. Par swaps
Par swaps involve a regular payment of the fixed and floating legs. Usually each time
there is a floating payment there is a corresponding fixed payment, as shown in figure 17.
Time
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Floating
Fixed
Time
Year 1
Year 2
Year 3
Year 4
Year 5
Floating
Year 6
Fixed
1Although actual rates will include a small margin for the investment bank.
Fixed
real
yield
(e.g. 1%)
Components of return
Pension
fund
Counter
party
Inflation swap
Actual
inflation
Pension
fund
Counter
party
Lets assume expected inflation is 3%. To emulate an index-linked gilt there are
two steps necessary:
Step 1 Enter an interest rate swap exchanging LIBOR (a type of floating short-
term cash rate) for a fixed rate of, say, 4%. Expected short-term interest
rates over the term are therefore expected to be 4%
Step 2 Enter an inflation swap. In this case expected inflation is 3%, so we
()
90.53
Present value =
100 x 1.03
10
10
= 90.53
10
1.01 x 1.03
Time
5
Present value
10
Inflation
100
We could use swaps to make certain this payment was met, no matter what the course
of future interest rates and inflation.
Assuming we have assets of 90.53 available (i.e. we are not underfunded) the two steps
necessary are:
S
tep 1 enter an interest rate swap with a notional value of 90.53. This will provide
a fixed payment of 43.86 in 10 years and, when added to our original 90.53, we
have a certain 134.39. This step locks in a real rate and expected inflation
S
tep 2 at the outset enter an inflation swap with a notional value of 100. This
will provide exposure to actual inflation. We will pay a fixed rate of 100 x expected
inflation = 100x1.0310 = 134.39 at expiry2. This payment is made from our starting
capital of 90.53, plus our 43.86 we received under the interest rate swap
Pension
fund
Inflation swap
receive fixed
134.39
Counter
party
Pension
fund
pay fixed
134.39
receive 100 uplifted
by actual inflation
Counter
party
Whatever happens to interest rates and inflation, we will be able to meet our benefit
payment of 100 increased by inflation.
Assume inflation was 2% in reality over the 10 years. The actual benefit we would
need to pay is 100 x 1.0210 = 121.90. Our interest rate swap would still leave us with
134.39 and we would exchange this under the inflation swap for 121.90 (the benefit
payment). This is shown in figure 22.
2In practice the notional principal does not change hands, so we would pay the 34.39 rather than 134.39.
()
Time
10
Inflation @ 2%
100
If inflation was 10%, everything in figure 22 would be the same except the two figures
circled in orange, which would be 100 x 1.1010 = 259.37. The benefit would still be met.
The conclusion is that our asset and liability are matched.
Swaptions
A swaption is an option in which the buyer has the right but not the obligation to enter a
swap on terms that are fixed when the option is bought. As markets move, the swaption
may or may not become valuable to the buyer. If the market moves unfavourably, the
swaption will expire without the buyer exercising the right to enter the swap and the
buyer has lost the premium.
If the swaption has some value at expiry, then the buyer will exercise their right to enter
the swap (although often they will settle for cash and not enter the actual swap).
For pension funds a swaption could be designed that increased in value if interest rates
were to fall. In this way the swaption would rise in value as would the liabilities, hence
risk would be reduced. Pension funds can also sell swaptions. If interest rates were to
rise, the swaption would be exercised against the pension fund, but the liabilities will
have fallen.
Longevity swaps
For pension funds, the risks associated with further increases in longevity have
moved up the agenda. This reflects a widespread focus on offsetting unrewarded or
unintentional risks.
Bulk annuity buyouts used to be the only available route for managing longevity risk.
However, greater demand has spurred multiple new entrants into the buyout market and
provoked innovative forms of risk transfer, including buy-ins and, now, longevity swaps.
Under such a swap arrangement, a scheme effectively forgoes the impact (positive
or negative) of changes in future longevity in return for retaining todays estimate of
future longevity. Uncertainty is replaced by certainty, via a structure that is similar to an
interest-rateswap.
Repurchase agreements
In a repurchase agreement repo, one party will sell an asset with an agreement to buy
back that asset at an agreed price on a specified future date. Repos are short-term
contracts with a typical maturity from overnight to several months, although maturities
of up to several years are possible. The largest and most liquid repo market is in gilts.
Repos allow investors to exchange gilts (or other assets) for cash and to buy them back
at a premium at a later date. The exchange of legal title on the gilts reduces credit risk
for the counterparty, which means repo investors can typically buy back the gilts at a
sub-LIBOR rate.
The difference between the price paid to repurchase the asset (the forward price) and
the price at which the asset is sold (the spot price) is analogous to the interest rate on a
loan. This is known as the repo rate and varies according to supply and demand in the
market. Typically the rate that applies for government bonds is the general collateral
(GC) repo rate.
Pension
fund
Counter
party
government bond
End of contract
government bond
Pension
fund
Counter
party
cash + interest
Repo markets provide a number of uses for LDI investors. Investors that wish to extend
hedging through the gilt market could repo out an existing gilts portfolio and use the
proceeds to purchase additional gilts. As the investor retains economic exposure to the
gilt assets repo-ed out, this means the investor achieves a leveraged exposure to gilts.
If the investor does not have an existing gilt portfolio but wishes to extend hedging
through the gilt market they can, alternatively, purchase gilts on a repo basis. This
transaction combines a simultaneous gilt purchase and repo transaction. The repo
transaction provides capital to purchase the gilt which is then used as collateral in the
repo transaction.
Repo markets can also provide short-term capital to assist with cashflow
management and are an efficient way to invest cash on a collateralised basis, albeit
at a sub-LIBOR rate.
Repo agreements are often rolled over at expiry to cover the required payment due.
Investors face the risk that they may not be able to roll over the agreement, and market
movements may make cash requirements larger than expected. Any rolling of a repo
with a different counterparty generates settlement risk. Investors must also be aware of
counterparty risk, although collateralisation limits the impact of counterparty default.
Counter
party
Client
financing leg
3M LIBOR spread
Transaction costs are incurred on the financing leg of the TRS, with no explicit fee being
charged. This spread to LIBOR is dependent on a number of factors, including supply and
demand and the extent to which the counterparty uses its own balance sheet to finance
thecontract.
Like repo agreements, investors face the risk that they will not be able to roll the
contract into another at expiry. If this happens, the investor will need to meet any cash
requirements owed on the contract. The investor is also exposed to counterparty risk, but
this is mitigated by collateralisation. Collateral is passed daily between counterparties
depending on each counterpartys mark-to-market position.
Synthetic equity
Equity exposure can be achieved synthetically (using derivative instruments) with
risk/reward characteristics similar to a direct physical equity investment. The most
common forms of synthetic equity exposure are achieved through the use of either
exchange-traded future contracts or equity TRS. Both methods enable investors to
gain exposure to equities without paying cash, freeing up assets for investment in
other assets, such as gilts.
Exchange-traded futures
An exchange-traded future contract is entered into through an exchange and provides a
return based on that of an underlying equity index. Before entering a position, investors
must post initial margin to cover any losses originating from their position over time.
Equity future contracts on major benchmark indices are highly liquid. In order to
construct a global benchmark such as the MSCI World, an investor would need to invest
in the underlying constituents based on their market capitalisation weights.
Pension
fund
Counter
party
financing leg
3M LIBOR spread
Physical assets
Gilts
50m
Equity
50m
Gilts
50m
Equity
50m
Swaps
25m
Physical assets
Equity
25m
Gilts
75m
Synthetic
equity
25m
Equity
25m
Gilts
75m
Synthetic equity investment carries with it the risks inherent in a physical equity
investment in addition to specific instrument risk. In equity futures, investors will
need to post initial margin, which varies between contracts and is a function of
market volatility. Mark-to-market losses require additional (variation) margin to
prevent the contract being closed out by the exchange.
In equity TRS, as with gilt TRS, investors are exposed to counterparty risk, which is
mitigated by collateralisation. There are also currency risks dependent on the contract
traded and an investors mark-to-market position.
Liability driven
investment
90.53
Present value = 100 x 1.03
10
10
= 90.53
10
1.01 x 1.03
10
Present value
Inflation
100
What would happen if we increase interest rates but keep inflation fixed i.e. we change
the real rate of interest? In the example below we keep inflation at 3% and interest rates
move to 5% (real rate moves to 2%).
The future value of benefits payable remains 134.39, but the present value falls to
82.03. This sensitivity is often called the interest rate sensitivity. So, if the move was
0.01% rather than 1%, we would have the Interest Rate PV011.
82.03
Present value = 100 x 1.03
10
10
= 82.03
10
1.02 x 1.03
10
Present value
Inflation
100
1PV01 is shorthand for the change in the present value given a 1 basis point change (0.01%) in rates.
What would happen if we kept interest rates the same at 4%, but changed the level
of inflation? If we change inflation from 3% to 2% (i.e. real rates move to 2%) we can
see in the following chart that the future value of benefits payable falls to 121.90,
but the present value changes to 82.03 from 90.53. This is often called the inflation
sensitivity. If the move was 0.01% rather than 1%, we would have the Inflation PV01.
82.03
Present value = 100 x 1.02
10
10
= 82.03
10
1.02 x 1.02
10
Present value
Inflation
100
For inflation-related benefits the interest rate and inflation sensitivities are generally
the same.
If liability payments are not linked to inflation fixed payments then the inflation
sensitivity will be zero. Fixed payments only have interest rate sensitivity.
Expected cashflow ()
Year
2010
2020
2030
2040
2050
2060
Step 2: Calculate the present value of these cashflows and compute the average time of
each as shown in figure 32. This is equivalent to finding the balancing point, assuming all
the cashflows were placed on a see-saw.
Expected cashflow ()
Year
2010
2020
2030
2040
2050
2060
20 years
For an average pension fund the duration is about 20 years. This means that if interest
rates fall by 1%, liabilities will rise by 20%. Liabilities are very sensitive to changes in
interest rates.
Expected cashflow ()
Year
2010
2015
2025
2035
2045
2055
2065
2075
5 years
Therefore, if the liabilities have a duration of 20 years and the assets five years, a 1% fall
in interest rates will increase the liabilities by 20%, but the assets by only 5%.
Many liability-driven strategies focus on increasing the interest rate sensitivity, or
duration, of the assets. In other words, they aim to reduce the interest rate sensitivity
mismatch between the assets and the liabilities.
An example
Lets look at an example of a pension fund with 250 million in liabilities, 80% of which
are inflation-related and the remainder of which are fixed. In order to value the liabilities
we could use swap rates appropriate to each liability cashflow. For example, the liability
cashflow expected to be paid in year 10 will be discounted at a different rate to the
liability cashflow expected to be paid in year 20.
2In practice, there is a weak short-term relationship between interest rates and equity markets although, in the long
term, lower interest rates should increase the value of equities as the discounted stream of dividends has a higher value.
Equities have an even weaker relationship with inflation. Companies pass on inflation through higher prices and so
equity markets exhibit a very muted response to inflation movements.
Present
value
(swaps
curve)
Duration
(sensitivity)
Inflation
PV01
Present
value of
0.01%
inflation
change**
Inflation-related liabilities
200m
18.5
370,000
370,000
Fixed liabilities
50m
18.2
90,000
Total liabilities
250m
18.4
460,000
370,000
Source: BlackRock. For illustrative purposes only. * We fix inflation and move the interest rate. This column is calculated
by multiplying the present value of liabilities by the duration (which would give the impact of a 1% move in interest rates)
and then dividing by 100 to give the impact of a 0.01% move. ** We fix interest rates and move inflation (hence we are
moving the real rate).
The table shows the duration of the liabilities is 18.4 years, meaning a 1% change in
interest rates will change the value of the liabilities by approximately 18.4% (46 million).
We can see that for every 0.01% move in interest rates, the liabilities will change in value
by 460,000. For inflation, the figure is similar with liabilities moving by 370,000.
Now you might think a 0.01% move in interest rates is nothing to get excited about.
However, interest rates often move by 0.50% in a year, which means the 460,000
mismatch becomes approximately 50 times larger (i.e. 23 million). As mentioned in the
swaps chapter, the reason for using 0.01% changes is that it reflects the way swaps are
quoted (in the present value for a 0.01% change in rates i.e. a PV01).
We now need to make some assumptions about the assets. Lets assume we have
assets currently valued at 200 million which are 75% equities and 25% over 15-year
gilts. The duration (interest rate sensitivity) of the equities is taken to be zero and the
duration of the gilts is 12 years. We could add the assets into the table above as well
as showing the mismatch.
Present value
(swaps curve)
Duration
(sensitivity)
Interest rate
PV01
Inflation
PV01
Inflation-related liabilities
200m
18.5
370,000
370,000
Fixed liabilities
50m
18.2
90,000
Total liabilities
250m
18.4
460,000
370,000
Assets
200m
3.0*
60,000
Mismatch
-50m
400,000
370,000
Source: BlackRock. For illustrative purposes only. * 75% of assets with a zero duration and 25% with 12 years gives an
average of 3.
The table at the foot of page 43 shows that for every 0.01% move in interest rates, the
liabilities will change in value by 460,000 but the assets will only change by 60,000
a mismatch of 400,000. For inflation the figure is similar with liabilities moving by
370,000 and the assets being insensitive to inflation changes3.
Interest rates and inflation are not the only sources of risk in a pension fund. Investing
in UK and overseas equities, property, hedge funds etc. will also give rise to risk versus
the liabilities. We can quantify these risks and display them in the following way for an
example scheme.
10%
8%
6%
4%
2%
0%
Interest rates and inflation
Total
The reason that the total risk is lower than the addition of the interest rate/inflation and
equity/property components is that there is a diversification effect between the two
(i.e. there is a less than perfect correlation). A common result for many pension funds is
that the risks stemming from movements in interest rates and inflation can be as high,
or higher, than those from holding equities. It must be borne in mind that interest rate
and inflation mismatch risks are generally regarded as unrewarded in the long term,
whereas holding equities/property etc. involves taking risk in the expectation of reward.
If we go back to the table at the foot of the previous page, we can see that if we
purchased an asset with a 400,000 sensitivity to 0.01% changes in interest rates
and a 370,000 sensitivity to 0.01% changes in inflation, then we could remove these
unrewarded risks, as shown in figure35.
3Note that the liabilities often include various types of inflation caps and floors. For example, some liabilities may be
capped at 5% inflation increases, some 3% and some 2.5%. So the absolute level of inflation is important.
10%
8%
6%
4%
2%
0%
Interest rates and inflation
Total
The residual risk would come purely from equities and property. Note that the reason
we do not explicitly show bonds on this chart is that bond holdings are subsumed into
the interest rates and inflation box. Also note that, for underfunded pension funds,
generally only a proportion of the interest rate and inflation risks is hedged (usually
limited to the size of the assets).
Company strength
strong
low
Funding level
high
large
small
Weak companies with large, underfunded pension funds clearly have the greatest
challenge and the lowest security for members. At the other end of the spectrum there
are a handful of large, strong companies with small, well-funded pension funds.
Liabilities
+ 2%
+1%
+0.5%
+1.5%
t(
emen
anag
m
e
Activ
()
exposure
Market
+1%
0%
Liabilities
7%
Expected risk versus liabilities
4A risk level of 7% means that, two-thirds of the time, the annual asset returns will be within 7% of the change in liabilities.
Asset return is expected to be in excess of liabilities +7% assuming normally distributed returns.
In the chart opposite we have shown three choices to achieve liabilities +2% with a
risk of 7% or less:
2% from active management (alpha) with no market exposure (beta)
1% from beta and 1% from alpha
1.5% from beta and 0.5% from alpha
There are of course many more combinations targeting liabilities +2%.
When trustees set their pension fund investment objectives, they are intrinsically
translating expectations of the liabilities into investment targets for the assets.
Here to stay
We hope this guide has demonstrated that LDI is about
developing investment strategies that achieve desired
risk-and-return targets relative to liabilities. This can
be implemented with the more traditional assets of a
pension fund equities, bonds or property although
much of the interest today is in the newer products we
have discussed.
The foundation of a liability-driven approach involves
assessing the sensitivities of both the assets and the
liabilities to a range of factors. These include inflation,
interest rates, equity markets and so on. The key is
to understand the level of risk relative to liabilities
encapsulated in the asset portfolio.
In the early days, LDI was narrowly defined and generally
involved structuring bond portfolios to meet the
cashflows paid to pensioners. LDI strategies are now
widely defined and encompass an holistic framework
by which assets are managed relative to the liabilities.
Outperforming the liabilities plays a central role,
particularly given most pension funds desire to close
funding gaps.
As an investment approach, LDI is more pertinent
than ever.
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governments, pursue their investing goals. We offer:
``
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managedaccounts, alternatives and iShares ETFs
``
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earning BlackRock the distinction of being trusted to manage more money than any
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insights@blackrock.com
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