You are on page 1of 52

FOR PROFESSIONAL CLIENTS ONLY

LDI
ESSENTIAL
GUIDE
ESSENTIAL
GUIDE
THE
BACKESSENTIALS
TO BASICS OF
LIABILITY DRIVEN
INVESTMENT

Contents

Understanding the liabilities

Interest rate and inflation swaps

17

Liability driven investment

37

TH E ES S E N T I A LS O F L I A B I LIT Y DRIV EN INV EST MENT

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

This guide will undoubtedly raise


additional questions in the minds of
readers please contact your account
manager for further information
on any ofthe topics covered or to
providefeedback.

T HE ESSENT IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[1]

[2] THE ES S E N T I A LS O F L I ABILIT Y DRIV EN INV EST MENT

Understanding
the liabilities

T HE ESSENT IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[3]

ONE THING BEFORE WE GET STARTED:


THE TIME VALUE OF MONEY
A pension fund is a complex financial entity and the key to
understanding its mechanics is the time value of money.
This simply concerns calculating the present value
(or value today) of a payment to be made in the future.
Time value of money and the actuarial valuation
In undertaking a valuation, the actuary uses a snapshot of the current membership of
a pension fund. For each member, the actuary projects into the future what benefits
that member is expected to receive and when the actuary expects them to be paid.
The fundamental question is: how much should we put aside today to meet the future
liability?
This is where the time value of money comes in. If a pension fund is expecting to pay a
benefit of, say, 1,000 in five years time, how much should be set aside today?
Now, if money can be invested in a cash account guaranteed to earn a rate of 4% per
annum, we could set aside:

1,000
1.04 x 1.04 x 1.04 x 1.04 x 1.04

1,000
(1.04)

821.93

If we set aside this amount, we would be certain to meet the payment.

Risk and return


Instead of cash, what if we could invest in corporate bonds which offered an expected
return of 6% over the next five years? Then we would only need to set aside 1,000/
(1.06)5 = 747.26. So we would need to set aside less today, but there is a risk that if
corporate bonds fall in value, we will not be able to meet the future payment. This is
where we start to balance higher expected returns with higher expected risks. We will
come on to risk in more detail later.
Equities might be expected to return 9% over the next five years. If we invested in
equities, we would only need to set aside 1,000/(1.09)5 = 649.93. This is substantially
less, but equities fluctuate in value and again we might not be able to meet the future
payment (or, if equities do better than expected, we may have more than 1,000 at the
end of year five). See figure 1.

[4] THE ES S E N T I A LS O F L I ABILIT Y DRIV EN INV EST MENT

FIGURE 1. TIME VALUE OF MONEY


()

@ 4%

1,000
800

1,000

@ 6%
822

@ 9%

747
650

600
400
200
0
Time

Value today (present value)

5 years time
Value today

5 years time

Source: BlackRock. For illustrative purposes only.

Actuarial valuation assumptions


Historically, the actuary had freedom to make assumptions about future investment
conditions based in part upon how a pension fund invested its assets. If the pension
fund was 70% in equities, expected to return 9%, and 30% in bonds, expected
to return 6%, the actuary might assume the appropriate rate to discount future
payments is (9% x 0.7 + 6% x 0.3) = 8.1%. However, risk was not fully factored into
this calculation.
Today the picture is different. The actuary has much less scope to make assumptions
and the discount rate is prescribed by accounting standards to a large degree. Under
IAS 191, for example, there is a necessity to discount all future liability cashflows using
the rate that could be earned on high-quality (AA-rated) corporate bonds. For other
purposes, government bond or swap rates are more appropriate. We will come back to
this later.

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.

T HE ESSENT IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[5]

UNDERSTANDING THE LIABILITIES


A pension funds liabilities are the benefits paid to members and consist of a series
of cashflows that the fund must pay out in the future. The cashflows are usually
calculated by the actuary and are based upon the aggregate forecast of all the benefits
for all members. Typically, the expected cashflows are based on a snapshot of existing
members and will not take account of future joiners.
Pension fund liabilities are long-dated. Their calculation involves forecasting far into the
future (70years or more) to estimate what payments will be made, as well as the value
that these distant payments should have today (by discounting to a present value using
the time value of money).
To understand what drives pension fund liabilities, lets take an example of a person aged
45with 10 years of service in a pension fund that accrues a pension of 1/60th of final
salary for each year of service (see details below).




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%)

[6] THE ES S E N T I A LS O F L I ABILIT Y DRIV EN INV EST MENT

FIGURE 2. FUTURE BENEFITS


()
5,000
4,000
3,000
2,000
1,000
0
Age 65 (20 years time)

Time

Price inflation

Wage inflation

Accrued benefit

Source: BlackRock. For illustrative purposes only.

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.

FIGURE 3. PRESENT VALUE FOR FUTURE PAYMENTS


()
10,000

This is the present value of the members liability

8,000
6,000
4,000
2,000
0
Time

Age 45 (Now)

Age 65 (20 years time)

Present value of liability cashflows

Price inflation

Wage inflation

Accrued benefit

Source: BlackRock. For illustrative purposes only.

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.

T HE ESSENT IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[7]

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

Market value of assets


Value of liabilities

Looking across a whole scheme, the liabilities can be represented as a series of


projected future cashflows. A typical aggregate cashflow profile is shown in figure4.
Each bar represents the amount expected to be paid from the pension fund in a
particular year.

FIGURE 4. CASHFLOW PROFILE

()

Time

2010

2020

2030

2040

2050

2060

2070

2080

Expected cashflow ()

Source: BlackRock. For illustrative purposes only.

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.

[8] THE ES S E N T I A LS O F L I ABILIT Y DRIV EN INV EST MENT

Expected cashflow ()

FIGURE 5. PENSIONERS AND ACTIVES/DEFERREDS

Time 2010 2015 2025 2035 2045 2055 2065 2075


Pensioners

2010 2015 2025 2035 2045 2055 2065 2075


Expected cashflow ()

Actives/deferreds

Source: BlackRock. For illustrative purposes only.

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.

Figure 6 overleaf shows future liability cashflows split between:


Limited

Price Indexation (LPI) benefits are linked to inflation subject to a floor of
0% (pensions cannot be reduced) and cap of 5%3 (pensions will be increased with
inflation up to 5% but if, for example, inflation is 6% for a particular year, the pension
will only rise by 5% for that year)
Retail

Price Inflation (RPI) benefits linked to inflation without a cap but might have
a floor of 0%
Fixed payment cashflows that do not depend on inflation levels

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%).

T HE ESSENT IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[9]

Expected cashflow ()

FIGURE 6. FUTURE LIABILITY CASHFLOWS

Year

2015

2020

2030

2040

2050

Inflation (LPI)

2060

2070

Inflation (RPI)

2080
Fixed

Source: BlackRock. For illustrative purposes only.

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.

What factors impact upon the value of theliabilities?


There is a distinction between the factors that impact upon the level of the promised
pension payments in the future (the estimated future annual cashflows) and the factors
that we use to estimate the value of these future payments in todays money.
The future payments made to beneficiaries change as a result of changes in life
expectancy (longevity), discretionary awards (benefits paid in excess of the promised
level), member service (length of time accruing benefits in the fund) and inflation
The current market value of these aggregate payments is sensitive to changes in the
discount (interest) rate. The current market value of the future payments increases
when rates fall, and vice versa, in a similar way to movements in the value of bonds

What is the real interest rate?


Generally, liabilities are quite sensitive to both interest rates and inflation. An important
aspect to understand is that interest rates have two components: expected inflation and
the real interest rate. The general relationship is as follows4:
Interest rate = expected inflation + real interest rate

4 The relationship is more accurately stated as (1 + nominal interest rate) = (1 + inflation) x (1 + real interest rate).

[10] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

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.

Why are real interest rates important?


Real interest rates play a very important role for pension funds. The present value of a
pension funds liabilities is usually highly sensitive to the real interest rate.
Assume we have to pay a benefit of 100 increased by inflation at the end of 10 years.
Further, assume interest rates (often called nominal interest rates, which include both
inflation and the real interest rate) are 4% and expected inflation is 3%. Therefore, the
real interest rate is 1%. The future value of the payment is expected to be 100 increased
by inflation i.e. 100 x (1.03)10 = 134.39 as shown in figure 7.

FIGURE 7. FUTURE VALUE OF PAYMENTS

10

100 x 1.03 = 134.39


()

Time

10
Inflation

100

Source: BlackRock. For illustrative purposes only.

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[11]

FIGURE 8. PRESENT VALUE CALCULATION


10

100 x 1.03 = 134.39

()

90.53
Present value = 100 x 1.03
10

10

= 90.53

10

1.01 x 1.03

Time

10
Present value

Inflation

100

Source: BlackRock. For illustrative purposes only.

Therefore, the present value equals:


the future value 100 x 1.0310 = 134.39, divided by 1.0410 = 90.53.
Now, the 1.0410 can be split between inflation and the real interest rate5:

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%.

[12] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

How volatile are the liabilities?


The future benefits (annual cashflows) include a degree of uncertainty as a result of
a number of factors including the incidence of early retirement and improvements in
mortality (known as demographic factors). Such factors cause estimation errors but it is
changes in interest rates that give rise to the significant volatility of the cost of providing
these benefits.
Historically, the volatility of liabilities was masked, as only triennial valuation snapshots
were carried out. A greater focus on the disclosure of the liabilities has shown that the
volatility of the liabilities may be even higher than that of the assets. Figure 9 shows the
perception that persisted for many decades. The market value of assets could clearly
be seen to be very volatile when viewed on a daily, monthly or quarterly basis. Since the
liability value was only considered very infrequently, often only every three years as part
of an actuarial valuation, there was a tendency to assume that this value was relatively
static in the interim.
In practice, liabilities are highly volatile, with their long-term nature making them
particularly sensitive to changes in the value of interest rates and inflation. Small
changes in interest rates, especially real interest rates, have had a significant impact
when applied over such a long-term horizon. What is important is whether the assets
and liabilities fluctuate in the same direction or move in opposite directions (which can
change the funding level substantially).

FIGURE 9.

PERCEPTION

(%)

REALITY
(%)

Time

Assets

Time

Assets

Liabilities

Time

Liabilities

Valuation

Time

Source: BlackRock. For illustrative purposes only.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[13]

Same liabilities, different value?


These days, there are quite a few ways to value the liabilities of a pension fund. The
differences arise principally due to the use of different discount rates to convert the
future values to present values. Some of the variations are shown in figure 10.

FIGURE 10. DISCOUNT RATES


Statutory Funding Objective?
Accounting (IAS 19)?

Expected cashflow ()

Pension Protection Fund?

Time

Swaps?
Buyout?

2010

2020

2030

2040

2050

2060

2070

2080

Expected cashflow ()

Source: BlackRock. For illustrative purposes only.

Lets examine some of these:



Statutory Funding Objective most trustees are probably familiar with this
valuation method. The Pensions Act 2004 introduced the Statutory Funding
Objective, which requires that schemes have enough assets to meet the value
of their liabilities (or technical provisions). The method and assumptions are
determined by the trustees and must be prudent and appropriate to the fund.
These will be determined with advice from the scheme actuary, must be agreed
with the employer and reviewed by the Pensions Regulator. The method and
assumptions are set out in the Statement of Funding Principles.
A
 ccounting (IAS 19) assets are measured at market value and liabilities will
be valued using the discount rate on long-dated AA-rated bonds. There is no strict
regulation regarding precisely which AA bonds to use. Some valuations will use
the discount rate from a single AA bond or index; others will use a range of AA bonds
to derive the rate used. Generally, a single discount rate will be selected to bring all
payments back to present values.

[14] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[15]

[16] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

Interest rate
and inflation swaps

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[17]

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.

[18] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

FIGURE 11. SIMPLE SWAP EXAMPLE


()
10

Fixed cashflows

Floating cashflows

e.g. the fixed interest payments


on 100 principal @ 5% (i.e. 5)

e.g. floating interest payments


on 100 principal
6

6
5

SWAP

2
0
Time

Year 1

Year 2

Year 3

Year 1
Fixed

Year 2

Year 3
Floating

Source: BlackRock. For illustrative purposes only.

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.

FIGURE 12. SWAP TERMINOLOGY


Term
Anything from a few months to
50 years. Cashflows can be swapped
quarterly, annually, at expiry etc.

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)

Source: BlackRock. For illustrative purposes only.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[19]

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.

A basic swap example


A swap is just that an agreement to exchange something for something else. Pension
funds usually want to gain more inflation exposure as their liabilities are dominated by
inflation sensitivity. Pension funds could seek to buy index-linked gilts, but the market
is relatively small and index-linked gilts are inflexible. Instead, the pension fund could
enter into a swap with a counterparty where the pension fund would swap something in
exchange for inflation exposure.
Lets assume expected inflation for the next 10 years is 3% (inflation expectations can
be observed in the market so all parties will agree on this).
The pension fund could contract with a counterparty, usually an investment bank, to
pay a fixed rate of 3% per year (which is the expected inflation figure) in return for actual
inflation which would float. The percentages would be applied to a notional principal,
which does not change hands. Lets assume the notional principal is 100.

FIGURE 13. SWAP EXAMPLE


Fixed (at expected inflation)

3
Pension
fund
3

3
Counter
party

4
2

Floating (actual inflation)


Source: BlackRock. For illustrative purposes only.

[20] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

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.

FIGURE 14. SWAP OUTCOMES


Inflation = expectations
Fixed (at expected inflation)

Inflation higher than expectatons

Inflation lower than expectations

Fixed (at expected inflation)

Fixed (at expected inflation)

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

Floating (actual inflation)


 No net impact on either party

Floating (actual inflation)


 Pension fund gains on swap
 Liabilities will have grown

Floating (actual inflation)


 Pension fund makes loss on swap
 Liabilities will have fallen

Source: BlackRock. For illustrative purposes only.

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[21]

The IBM/World Bank swap


In August 1981, IBM and the World Bank entered into one of the first large-scale swap
transactions. This swap has the reputation for kick-starting the swaps market because
it was performed by two prestigious organisations. It was the first long-term swap
undertaken by the World Bank, now one of the biggest users of swaps.
The background to the swap, in brief, was that IBM had embarked on a worldwide
funding programme some years earlier, raising money in deutschmarks and Swiss
francs. The money was remitted back to the US for general funding, which introduced
currency risk as IBM converted US dollars into deutschmarks and Swiss francs to
pay coupons.
The World Bank was a prolific borrower in deutschmarks and Swiss francs at the time but
was finding that the cost of borrowing was rising as its borrowing volume increased.
The solution was a swap agreement whereby IBM converted its deutschmarks and
Swiss franc liabilities to US dollars, and the World Bank, through IBM raising funds,
gained access to cheaper funding. Both parties achieved their objectives.

Swaps are part of a structure


Swaps must always be viewed as part of an overall structure in isolation their benefit
can be hard to deduce. While an actual swap contract will only bind the pension fund and
counterparty, both sides have other financial interests outside of the swap. The pension
fund will have its liabilities and the counterparty will usually have entities from which it
sources its side of the swap, for example a utility that has inflation-linked revenues.

FIGURE 15. OVERALL STRUCTURE

Liabilities

Pension
fund

pay
receive

Source: BlackRock. For illustrative purposes only.

[22] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

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.

What does the investment bank do?


Investment banks are different from high street banks. An investment bank does not
deal with retail customers, instead focusing on large transactions involving companies
and professional investors.
Investment banks entering swaps do not generally seek to profit from taking on explicit
risks per se, but instead look to hedge their swap position by entering into an opposing
transaction either with another counterparty or by using physical instruments directly.
The terms of the swap will include a margin (fee) for the service provided by the
investment banks.

Types of swap
Pension funds generally enter into two types of swap inflation swaps and interest
rate swaps.

FIGURE 16. TYPES OF SWAP


Inflation swap

Interest rate swap

Swap fixed cashflows for realised inflation cashflows

Swap fixed cashflows for floating cashflows (floating


cashflows usually based on short-term interest rates)

Pension
fund

pay fixed

Counter
party

receive inflation

Pension
fund

pay floating

Counter
party

receive fixed

Source: BlackRock. For illustrative purposes only.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[23]

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.

FIGURE 17. PAR SWAP PAYMENTS


()

Floating: pay quarterly LIBOR payments


Fixed: receive quarterly fixed payments

Time

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6
Floating

Fixed

Source: BlackRock. For illustrative purposes only.

Par swaps have traditionally been the most common.

2. Zero coupon swaps


Zero coupon swaps occur where the parties do not exchange cashflows throughout the
term and exchange only at expiry, as represented in figure 18.

[24] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

FIGURE 18. ZERO COUPON SWAP PAYMENTS


()

Swap fixed for floating

No payments exchanged over term

Time

Year 1

Year 2

Year 3

Year 4

Year 5
Floating

Year 6
Fixed

Source: BlackRock. For illustrative purposes only.

How is the fixed rate determined?


If we consider a basic floating-for-fixed interest rate swap, the most obvious difficulty
in setting the fixed rate is the fact that the future stream of floating rate payments is
unknown at inception.
The fixed rate is always equal to the expected value of the floating rate1. So if the expected
value of the floating side of a swap is 4%, this becomes the fixed rate and the swap
becomes a fixed 4% versus floating payments which have an expected value of 4%.
Many swaps will have a fixed rate that is based on the expected value of LIBOR. LIBOR is
not a risk-free rate and reflects the counterparty risk in the inter-bank market.

Using swaps to replicate an index-linked bond


Pension fund liabilities are closely linked to inflation. Traditionally, pension funds seeking
assets sensitive to inflation would purchase index-linked gilts, although the size of this
market is only a fraction of the size of pension fund assets. Pension funds have therefore
looked to other places for inflation-sensitive assets and a combination of interest rate
and inflation swaps can provide a return similar to that of an index-linked gilt.
Figure 19 overleaf shows how an interest rate swap and inflation swap can be combined.
An index-linked gilt has two components of return: a real yield fixed at the outset and
actual inflation. In this example, the return each year from the index-linked gilt is 1% +
inflation multiplied by the principal.

1Although actual rates will include a small margin for the investment bank.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[25]

FIGURE 19. COMBINING INTEREST RATE AND INFLATION SWAP


Index-linked gilt

Interest rate swap

Fixed
real
yield
(e.g. 1%)
Components of return

Pension
fund

pay floating (LIBOR)


receive fixed e.g. 4%

Counter
party

Inflation swap

Actual
inflation

Pension
fund

pay fixed e.g. 3%


receive actual
inflation

Counter
party

Source: BlackRock. For illustrative purposes only.

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

swap a fixed 3% against actual inflation


Entering an interest rate swap has the effect of fixing both the real yield and inflation.
The inflation swap exchanges fixed inflation for actual inflation.
The net effect is that the real yield has been fixed at 1% (we receive fixed 4% and pay
fixed 3%) and we receive actual inflation just like an index-linked gilt.

[26] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

Meeting future payments


In chapter 1 we introduced the example of a benefit of 100 increased with inflation
payable after 10 years. In that example we assumed interest rates were 4% with a real
interest rate of 1% and expected inflation of 3%. The future expected value of the benefit
is 100 x inflation = 100 x 1.0310 = 134.39.
In this example we shall use a swap rate to discount the cashflow, rather than an interest
rate. Note that the swap rate may be different from this interest rate but, for simplicity,
lets assume the swap rate is 4%, rather than a slightly higher number.
The present value of the liability is 134.39 discounted by the swap rate = 134.39 /
(1.0310 x 1.0110)= 90.53.

FIGURE 20. DISCOUNTING WITH SWAP RATE


10

()

100 x 1.03 = 134.39

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

Source: BlackRock. For illustrative purposes only.

We could use swaps to make certain this payment was met, no matter what the course
of future interest rates and inflation.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[27]

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

FIGURE 21. TWO-STEP PROCESS


Interest rate swap

Pension
fund

Inflation swap

pay floating (LIBOR)

receive fixed
134.39

Counter
party

Pension
fund

pay fixed
134.39
receive 100 uplifted
by actual inflation

Counter
party

Source: BlackRock. For illustrative purposes only.

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.

[28] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

FIGURE 22. INFLATION EXAMPLE


10

()

100 x 1.02 = 121.90


Interest rate swap
We have paid LIBOR for 10 years
We receive back a fixed 134.39
Inflation swap
10
We have to pay 100 x 1.03 = 134.39
10
We get back 100 x 1.02 = 121.90

Time

10
Inflation @ 2%

100

Source: BlackRock. For illustrative purposes only.

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.

Swaps and collateral


Entering into a swap arrangement involves being exposed to the creditworthiness of the
counterparty. In practice, this risk can be significantly reduced via collateralisation.
For an actual loss on a swap to occur, two things must happen. First, the investment
bank must default and, second, the swap must have a positive value to the party that
does not default (pension fund).
To mitigate this risk, swaps can be collateralised. This means that when one party owes
money to the other, it is passed across as collateral (in securities of equivalent value)
prior to payment. In practice, swaps are usually valued daily and collateral payments
are calculated accordingly. Most swaps include thresholds such that there is no need to
transfer small amounts of money, which would be inefficient for both parties.
Collateralisation has profound implications for the credit risk exposure a pension
fund takes on when it enters a swap. In the event that the investment bank defaults
completely, the collateral means that no money has been lost up to that point.
A new swap could be struck with another counterparty, although this may be
challenging and the costs of replacing the position are subject to the appetite of other
counterparties to undertake the position and associated costs.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[29]

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.

Alternative hedging strategies


Since the end of the financial crisis, sterling swaps have traded at a premium to
government bonds (gilts), leading many LDI investors to look for other ways to hedge
inflation and interest rate risk. Leveraged gilt strategies such as repurchase agreements
and gilt total return swaps are effective alternatives.
They offer LDI investors a more cost-efficient way to hedge with gilt exposures because
they require no cash investment and benefit from the yield pick-up over swaps. However,
like conventional swaps, they can also provide a more flexible way to hedge than by
using physicalgilts.
In addition, LDI investors have found that synthetic equity strategies are a flexible way to
free up physical cash to increase their gilt exposure.

[30] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

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.

FIGURE 23. REPO STRUCTURE


Start of contract
cash

Pension
fund

Counter
party
government bond

End of contract
government bond

Pension
fund

Counter
party
cash + interest

Source: BlackRock. For illustrative purposes only.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[31]

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.

Gilt total return swaps


A gilt total return swap (TRS) exchanges cashflows linked to the return of a gilt, or
number of gilts, in return for a set of cashflows linked to a cash rate (typically LIBOR)
plus a financing spread. Gilt TRS have similar risk/reward characteristics to a direct
physical investment in agilt, basket of gilts or a gilt index.
As with interest rate and inflation swap contracts, gilt TRS do not require any initial
outlay to enter the position. This is because, at the inception of the contract, each
cashflow has an equal present value. Any difference between the two cashflows is
exchanged at the expiry of the contract. This allows LDI investors to gain exposure to a
bond-like asset without requiring any initial capital outlay, providing an investor with the
ability to leverage their portfolio.
Gilt TRS contracts are over-the-counter (OTC) instruments. Terms can be tailored to meet
investors needs and often differ from the maturity of the underlying gilt. A typical term
for a gilt TRS is between 6 months and 3 years, at which time a new contract would need
to be struck to maintain the exposure. A simple TRS payment structure is highlighted
infigure 24.

[32] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

FIGURE 24. GILT TRS STRUCTURE


return leg
gilt total return

Counter
party

Client
financing leg
3M LIBOR spread

Source: BlackRock. For illustrative purposes only.

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[33]

Equity total return swaps


An equity TRS exchanges cashflows linked to the return of a basket of stocks in return
for cashflows linked to a cash rate (typically LIBOR) plus a financing spread. In practice,
only the difference between the two cashflows is exchanged at the expiry of the contract.
Equity TRS have similar risk/reward characteristics to a direct physical investment in a
basket of stocks.
As an OTC product, each TRS contract can be tailored. For investors looking for global
exposure, a TRS referencing the MSCI World Index provides relatively good liquidity.
An investor can also build their global exposure through the use of regional or single
country indices if they wish to hold a custom global benchmark.
A typical term for an equity TRS is between 6 months and 3 years, at which time a new
contract would need to be struck to maintain the exposure. A simple TRS payment
structure is highlighted below.

FIGURE 25. GILT TRS STRUCTURE


return leg
equity index total return

Pension
fund

Counter
party
financing leg
3M LIBOR spread

Source: BlackRock. For illustrative purposes only.

Synthetic equity within a portfolio


Synthetic equity strategies allow LDI investors to replicate an existing physical equity
portfolio. They can then use the cash that was previously locked into this physical
portfolio to buy gilts and benefit from the yield pick-up relative to swaps.
In figure 26 we show how the use of synthetic equity can achieve the same overall
exposures as a traditional portfolio of equities, gilts and swaps. Both portfolios have a
50m exposure to equities (either physical equities or synthetic equities) and a 75m
exposure to interest rate and inflation assets (either gilts or swaps). However, in Portfolio
B the leverage is gained through the use of synthetic equity instruments rather than
swaps (see Asset Exposure), allowing more of the physical assets to be invested in gilts.

[34] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

FIGURE 26. PORTFOLIO A


Asset exposure

Physical assets

Gilts
50m

Equity
50m

Gilts
50m

Equity
50m

Swaps
25m

Source: BlackRock. For illustrative purposes only.

FIGURE 27. PORTFOLIO B


Asset exposure

Physical assets

Equity
25m
Gilts
75m

Synthetic
equity
25m

Equity
25m
Gilts
75m

Source: BlackRock. For illustrative purposes only.

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[35]

[36] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

Liability driven
investment

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[37]

LIABILITY DRIVEN INVESTMENT (LDI)


LDI is an investment philosophy, not a product. LDI is
about developing investment strategies that achieve
desired risk-and-return targets relative to liabilities.
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 plug funding gaps.
A common question is whether it is necessary to adopt an investment objective in the
form of liabilities + x% to pursue a liability-driven approach? The answer is no, although
if some of the assets are allocated towards matching the liabilities then it makes sense
to assess these assets relative to the change in liabilities.
The majority of UK pension funds currently have a scheme-specific benchmark e.g. 40%
UK equities, 20% overseas equities, 30% bonds and 10% property. These strategies
are designed to outperform the liabilities and, based on certain assumptions, it is
possible to convert a scheme-specific strategy into a liability-driven equivalent. A
typical investment strategy of 60% equities and 40% in matching assets is equivalent to
targeting a return on liabilities +2% to 3%.

The liability profile and current assets


In chapter 1 we noted that when we use a real interest rate, the present value of pension
fund liabilities that are linked to inflation is not sensitive to changes in inflation.
In our example a 100 benefit is payable in 10 years and is increased by inflation but it
will always have a present value of 90.53.

[38] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

FIGURE 28. PRESENT VALUE


10

100 x 1.03 = 134.39

90.53
Present value = 100 x 1.03
10

10

= 90.53

10

1.01 x 1.03

10

Present value

Inflation

100

Source: BlackRock. For illustrative purposes only.

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.

FIGURE 29. INTEREST RATE SENSITIVITY


10

100 x 1.03 = 134.39

82.03
Present value = 100 x 1.03
10

10

= 82.03

10

1.02 x 1.03

10
Present value

Inflation

100

Source: BlackRock. For illustrative purposes only.

1PV01 is shorthand for the change in the present value given a 1 basis point change (0.01%) in rates.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[39]

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.

FIGURE 30. INFLATION SENSITIVITY


10

100 x 1.02 = 121.90

82.03
Present value = 100 x 1.02
10

10

= 82.03

10

1.02 x 1.02

10
Present value

Inflation

100

Source: BlackRock. For illustrative purposes only.

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.

Applying duration to pension fund liabilities


Duration, which is conventionally used in connection with bonds to assess the sensitivity
of the price of a bond to changes in interest rates, can also be applied to liability
cashflows.
Step 1: Determine the liability cashflows as shown in figure 31.

[40] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

Expected cashflow ()

FIGURE 31. LIABILITY CASHFLOWS

Year

2010

2020

2030

2040

2050

2060

Source: BlackRock. For illustrative purposes only.

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 ()

FIGURE 32. PRESENT VALUE AND AVERAGE TIME

Year

2010

2020

2030

2040

2050

2060

20 years

Source: BlackRock. For illustrative purposes only.

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[41]

Applying duration to pension fund assets


We can also calculate the duration of a pension funds assets. To do this we would
project expected cashflows from the assets and convert these to present values.
The duration, or interest rate sensitivity, of the assets is generally much lower than the
liabilities. Often the figure will be about five years2.

Expected cashflow ()

FIGURE 33. EXPECTED CASHFLOW

Year

2010

2015

2025

2035

2045

2055

2065

2075
5 years

Source: BlackRock. For illustrative purposes only.

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.

[42] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

The results are summarised in the following table.

Present
value
(swaps
curve)

Duration
(sensitivity)

Interest rate PV01


Present value of
0.01% real interest
rate change*

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[43]

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.

FIGURE 34. EXAMPLE SCHEME RISKS

Risk versus liabilities

10%
8%
6%
4%
2%
0%
Interest rates and inflation

Equities and property

Total

Source: BlackRock. For illustrative purposes only.

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.

[44] TH E ES S E N T I A LS O F LIABILIT Y DRIV EN INV EST MENT

FIGURE 35. REMOVING UNREWARDED RISK

Risk versus liabilities

10%
8%
6%
4%
2%
0%
Interest rates and inflation

Equities and property

Total

Source: BlackRock. For illustrative purposes only.

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).

The strength of the plan sponsor


The strength and attitude of the plan sponsor is all-important to the ongoing viability
of a pension fund. Trustees should take into account the strength of the sponsor when
deciding how much investment risk to take. Clearly, strong companies with high levels of
free cashflow in their businesses are in a much better position to finance pension funds
than weaker companies. Consequently, this may warrant taking more investment risk to
fund the liabilities more cheaply over the long term. The strength of the plan sponsor has
a much greater bearing in the short term on underfunded pension funds. There are three
measures that link the strength of the sponsor with the pension fund:

FIGURE 36. REMOVING UNREWARDED RISK


weak

Company strength

strong

low

Funding level

high

large

Size of pension fund relative to company

small

Source: BlackRock. For illustrative purposes only.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[45]

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.

The risk budget and investment objectives


The key question to answer here is how much risk should be taken relative to the
liabilities. The underlying analysis will be a risk-budgeting exercise, which will determine
the overall risk constraints of the portfolio and the aggregate target outperformance.
It may also set targets for how much of the outperformance will come from market
exposure (beta) and how much from active management (alpha). For example, a target of
2% outperformance over liabilities might be adopted with a maximum risk level of 7%4.
In figure 37 we are aiming for outperformance at liabilities + 2%. The shaded area shows
the portfolios that have a risk of less than 7%. The blue line shows choices regarding
market exposure (beta) and the purple show active management choices.

FIGURE 37. RISK AND RETURN VERSUS THE LIABILITIES


Expected
return
+2%

Liabilities
+ 2%

+1%

+0.5%
+1.5%

t(
emen
anag
m
e
Activ

()
exposure
Market

+1%

0%
Liabilities

7%
Expected risk versus liabilities

Source: BlackRock. For illustrative purposes only.

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.

[46] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

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.

T HE ESSEN T IALS O F LI A BI LI TY D RI VEN I NVESTM ENT[47]

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.

[48] TH E ES S E N T I A LS O F L IABILIT Y DRIV EN INV EST MENT

T HE ESSEN T IALS OF LI A BI LI TY D RI VEN I NVESTM ENT

WHY BLACKROCK
BlackRock helps people around the world, as well as the worlds largest institutions and
governments, pursue their investing goals. We offer:
``
A comprehensive set of innovative solutions, including mutual funds, separately
managedaccounts, alternatives and iShares ETFs

``
Global market and investment insights
``
Sophisticated risk and portfolio analytics
We work only for our clients, who have entrusted us with managing $4.77 trillion*,
earning BlackRock the distinction of being trusted to manage more money than any
other investment firm in the world.
*AUM as at 31 March 2015.

Want to know more?


+44 (0)20 7743 3300

insights@blackrock.com

blackrock.com

This material is for distribution only to those types of recipients as provided below and should not be relied upon by any other persons. This material is provided for
informational purposes only and does not constitute a solicitation in any jurisdiction in which such solicitation is unlawful or to any person to whom it is unlawful.
Moreover, it neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to it by making an
offer to enter into an investment agreement. This material may contain forward-looking information that is not purely historical in nature. Such information may
include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, certain historical
performance information of other investment vehicles or composite accounts managed by BlackRock has been included in this material and such performance
information is presented by way of example only. No representation is made that the performance presented will be achieved by any BlackRock Funds, or that every
assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered
or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment
returns that are presented herein by way of example. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a
recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of 20September2015 and
may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources
deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will
come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this
material is at the sole discretion of the reader. Past performance is no guarantee of future results. In the UK issued by BlackRock Investment Management (UK)
Limited (authorised and regulated by the Financial Conduct Authority). Registered office: 12 Throgmorton Avenue, London EC2N 2DL. Registered in England No.
2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management
(UK) Limited. In Hong Kong, the information provided is issued by BlackRock (Hong Kong) Limited and is only for distribution to professional investors (as defined
in the Securities and Futures Ordinances (Cap. 571 of the laws of Hong Kong)). In Singapore, the information provided is distributed by BlackRock Investment
Management (Singapore) Limited and is for distribution to institutional investors (as defined in section 4A of the Securities and Futures Act, Chapter 289 of
Singapore (the SFA) and accredited investors (as defined in section 4A of the SFA) only. For distribution in EMEA, Korea, and Taiwan for Professional Investors only
(or professional clients, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. This material is being distributed/issued in
Canada, Australia and New Zealand by BlackRock Financial Management, Inc. (BFM), which is registered as an International Advisor with the Ontario Securities
Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial
Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation
is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities
law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility
arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or
agents. This document contains general information only and is not intended to represent general or specific investment advice. The information does not take into
account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial
situation and needs. THIS MATERIAL IS HIGHLY CONFIDENTIAL AND IS NOT TO BE REPRODUCED OR DISTRIBUTED TO PERSONS OTHER THAN THE
RECIPIENT. 2015 BlackRock, Inc., All Rights Reserved. 004818a-INST-I-SE-EN-ICB-0331

You might also like