Liability driven investment (LDI)
Pension schemes’ liabilities typically stretch over many decades and their present value is directly linked to inflation, interest rates and the longevity of their members. An LDI solution invests some of the pension scheme’s assets to help manage these liability risks. This means that if interest rates change or inflation expectations change, assets and liabilities rise or fall together and the funding level of the pension scheme should be less volatile. With pension liabilities rising over recent years, LDI strategies have helped many pension schemes to hedge their liability risks effectively.
Partially-funded instruments, such as swaps, are often used to provide investment exposures without a substantial commitment of initial capital. Swaps provide pension schemes with flexibility in managing liability interest rate and inflation risks. However, they introduce bank counterparty risk. As part of our stewardship responsibilities, Insight manages the risks associated with swaps through processes including collateralisation and counterparty risk management.
Insight’s Credit and Counterparty Exposure Committee (CCC), chaired by Insight’s Chief Risk Officer, oversees this critical issue. The CCC was established to ensure that Insight exercises due care and diligence in the selection and monitoring of counterparties with whom Insight will deal as agent on behalf of its clients. A key facet of this is to monitor closely the creditworthiness and business strategies of such counterparties, which involves regular face-to-face meetings between the bank management teams and Insight’s credit analysts, Insight’s senior legal staff and members of Insight’s executive management team.
Insight considers systemic issues in a number of different ways. In our LDI business, the use of interest rate and inflation swaps introduces bank counterparty risk. As previously mentioned, Insight is highly experienced at managing the risks associated with swaps through counterparty risk management and collateralisation. Insight was one of the pioneers of LDI and from the outset, recognising its importance to clients, introduced the daily collateralisation of swap positions.
Previously, industry best practice had been for weekly or even monthly collateralisation which, in light of Lehman Brothers’ failure, could have led to significant losses for pension schemes. As the credit quality of many banks has deteriorated following the global financial crisis, Insight has increasingly sought to protect its clients by strengthening further its daily collateral requirements and additional protections provided to clients.
Insight has also been vocal in lobbying for LDI clients in a world where regulators are pushing hard for clearing houses as a solution to help mitigate bank counterparty risk. While the use of clearing houses is supported by Insight, if the collateral deposited as margin is limited to cash, it is highly inefficient for pension schemes which typically operate with little cash, but tend to be long high quality assets such as government bonds. Moreover, if rates were to rise sharply, to meet margin calls pension schemes could be forced to sell assets to raise cash, at a time when many other pension schemes and other investors were doing the same. This would have the effect of exacerbating the downward movement in asset prices and, potentially, force pension schemes to liquidate assets in a falling market.
Issues relevant to our LDI clients that Insight engaged on with regulators in 2016 included the following:
Joint response to call for evidence on EU regulatory framework for financial services - January 2016: Insight collaborated with a wide range of European pension funds, pension fund service providers and pension stakeholders to a call for evidence issued on the overall financial services regulatory framework in the European Union. While policymakers have historically taken into consideration the wider impact of these initiatives, we were concerned that new regulatory developments could result in unintended consequences for European pension funds and pensioners. Following this engagement, the EU Commissioner invited Insight and its peers to discuss the content of our letter.
Response to DG FISMA consultation paper on further considerations for the implementation of the NSFR in the EU - June 2016: Insight responded to the consultation paper issued by the Directorate-General for Financial Stability, Financial Services and Capital Markets Union (DG FISMA) in focusing on further considerations for the implementation of the Net Stable Funding Ratio (NSFR) in the European Union (EU).
Response to the Basel Committee on Banking Supervision consultative document on revisions to the Basel III leverage ratio framework – July 2016: Insight responded to the consultation paper published by the Basel Committee setting out the following views:
- High quality government bond securities, with appropriate haircut, should be permitted to offset replacement cost in over-the-counter (OTC) derivatives exposure calculation.
- Standardised approach for counterparty credit risk (SA-CCR) methodology disproportionately penalises one-directional European pension fund portfolios.
- Initial margin should be permitted to offset both cleared and non-cleared trades.
- Treatment of inflation swaps within SA-CCR should be explicit and the asset class should be categorised within the same asset class as interest rates.
- Repo markets should not be allowed to be disproportionately affected by the leverage ratio rules.
Response to the ESAs’ opinion on risk mitigation techniques for non-cleared OTC derivatives under EMIR - September 2016: Insight expressed its support for the European Commission’s efforts to make the EMIR Regulatory Technical Standards on risk mitigation techniques for non-cleared trades workable for the industry as published, and queried the opinion of the European Supervisory Authority on risk mitigation.
Responses are available to read in full here.
Insight North America LLC (INA) is a registered investment adviser under the Investment Advisers Act of 1940 and regulated by the US Securities and Exchange Commission. INA is part of “Insight” or “Insight Investment”, the corporate brand for certain asset management companies operated by Insight Investment Management Limited including, among others, Insight Investment Management (Global) Limited, Insight Investment International Limited, Cutwater Asset Management Corp., and Cutwater Investor Services corp. Insight’s assets under management are represented by the value of cash securities and other economic exposures, and are calculated on a gross notional basis. Advisory services referenced herein are available in the US only through INA.
The views herein represent the opinions of Insight and are subject to change based on subsequent developments. They are not intended as investment advice or to predict or depict the performance of any investment. The material contained herein is not intended to provide, and should not be relied on for, investment, accounting or legal tax advice. Further, this material does not constitute a recommendation to buy, sell or hold any security. No offer or solicitation for the sale of any security or financial instrument is made hereby.
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