LDI health check | Insight Investment

Hello, my name is Emily Tan and today I'm going to be talking about your LDI portfolio. Now this is your largest, most significant and most complex mandate. Whether you are preparing for a buyout or planning to run on the LDI portfolio is the engine behind the whole strategy. And like any engine, it needs a regular health check. So let's think of this session like an MOT for your LDI portfolio, but instead of just checking the brakes and the headlights, we're gonna look under the bonnet at the full system. I'm going to walk you through the practical checks every trustee should be running to make sure your LDI setup is robust, resilient, and genuinely fit for the journey your scheme is on. So why is now the right moment to review your LDI setup? There are four main reasons.

First is good governance to proactively test your operational preparedness and resilience rather than waiting for stress events to expose weakness. And it's not just us that thinks that the regulator is encouraging it too in a recent review. Thirdly, you might find opportunities to do things better, be that by strengthening the hedge design collateral efficiency or different governance structures. And finally, your end game decision may have changed the picture. Many schemes have recently been thinking seriously about run-on versus buyout. Once you've clarified the journey plan, then it is a good time to revisit whether the LDI portfolio aligns with that destination. Okay, so here is your LDI service menu, and we're going to do this in three areas. Firstly, hedge design, looking at your hedge ratio, how you manage inflation caps and flaws in your liabilities and the instrument selection within your portfolio.

Then we're going to look at collateral management, looking at whether your collateral is being managed efficiently, have you got enough resilience to withstand a big stress event? And have you got a good mix of funds that can be used to source collateral from? And thirdly, we're going to look at the management of other risks, which can typically be collateralized from the same pool as your LGI portfolio, namely equity currency and longevity. And I'll also talk a little bit about the trends we are seeing in each of these areas. So let's start with hedge design, which may seem like the most basic area, but is also the most fundamental one and the one that can have the biggest overall impact on your outcome. So what are the areas to consider? First and foremost, you want to make sure you have the right amount of hedging. Now, it was very clear in late 2022 that the right amount of hedging was a function of liquidity schemes that were fully hedged, needed enormous liquidity as yields rose.

But schemes that were slightly under hedge often benefited as rising yields, improved funding levels so they could afford to sell some of the growth assets to top up their collateral. So most schemes want to be highly hedged, but not necessarily fully hedged. And for schemes that are running on or targeting a surplus, another consideration is whether your hedging either your funding level, so aiming to protect your current funding level or hedging the monetary value of your surplus. These are two slightly different objectives that would lead to a different choice of hedge ratio. So it's very important that you are clear on what your objective is as is. Ultimately you will dictate what amount of hedging is appropriate now as well as the size of your hedge. You also need to consider the shape is actually man matching your liabilities. During the gilts crisis, we saw that some schemes were forced into shapes that didn't reflect the shape of their underlying liabilities.

And so they would have a lot of what we call curve risk. So a big curve move like ones we've seen recently in markets, for example, with long move, long rates moving one way and short-term rates moving a different way can give outcomes very different to what you might expect if your shape is mismatched. Next, how are you managing inflation caps and flaws in the real world? Pension benefits are complex with inflation linkages subject to certain caps and flaws, so they're often hedged using a simplified representation. This representation needs to be updated to ensure it remains suitable, particularly if there have been big changes in market conditions since the last refresh. You need to ensure that the frequency of the refresh is appropriate. If it's too infrequent, it could have drifted too far from your underlying benefits, so you could have the wrong amount of inflation protection in your assets. But on the flip side, if you refresh it too frequently, this may lead to excessive trading and some schemes are now actually delegating this to us and giving us a benchmark with the caps and flaws embedded in it rather than the simplified representation.

And finally, you've got a different choice of instruments within your LDI portfolio. For example, you could hedge interest rates using gilts or swaps, the optimal mix of these two changes over time. So it's good to review this or alternatively you can delegate this to us. And that's definitely a trend we're seeing more and more of particularly among schemes are choosing to run on. And so who have a longer time horizon. So many clients who have chosen to delegate these decisions have seen meaningful improvements in funding levels through discretionary hedge management. Our approach is built from three core core principles which explain why delegation works and how value is added. So let me walk you through them.

Firstly, LDI benchmarks are important, but they're not a perfect match for the complex pension scheme. Liabilities, they reflect many Underlying assumptions and different actuaries of different investment in consultants could quite reasonably produce different LDI benchmarks using the same underlying information. Secondly, efficiency matters more than replication. A portfolio hugging the benchmark isn't always the most efficient. As we said earlier, interest rate and inflation risks can be hedged using a variety of instruments and the most cost effective mix changes over time. So thirdly, markets present opportunities. If you're positioned to act passive LDI investors dominate the market. So pricing opportunities often emerge due to supply demand imbalance or regulatory shift.

The bit the ability to take advantage of these depends on the governance model and the level of discretion delegated to asset management. And just to highlight this last point here is a chart that shows the 20 year gilt yields in light green and the difference between the gilt and swap yield in dark green. And this is just to show that there's constantly change in opportunities even in our little corner of the market where we're looking at gilts and swaps and curve shape, for example. So how meaningful is discretionary hedge management versus some other factors? Since the discretionary LDI aims to outperform the liability benchmark, even small differences can be meaningful because they apply to the whole of this liability value, not just a slice of the assets. Our discretionary portfolios have historically delivered an average outperformance of oh 0.4% per annum. To put the scale of this into context, let's compare it to some other targets and costs that might be meaningful to a scheme. A typical low dependency target is gilts plus oh 0.5%.

The cost of a longevity swap is around gilts plus oh 0.2% and credit spreads are around oh 0.8%. So you'd need to put 50% of your assets into credit to achieve achieve the same gilts plus 0.4% at a total portfolio level. All this to say the impact can be really material. So next, let's look at collateral management. This was an area that was a major focus in the regulator's recent guidance. Now let's look at what the regulator reviewed. They looked at five different areas. Firstly, schemes compliance with their guidance on interest rate buffers By interest rate buffer, I mean, how much of a change in interest rates can be withstood by the amount of collateral.

After the events of 2022, the regulator introduced guidance. The scheme should have a 2.5% stress buffer, so be able to support an immediate 2.5% event, and also an additional operational buffer above this to protect that 2.5% stress buffer day to day. Next, they looked at the process for recapitalization. They want to see that schemes have a well-defined process in place to restore buffers quickly rather than scrambling during times of stress. They also encourage delegation where appropriate. For example, having the LDI manager responsible for topping up the collateral pool. Next, they wanted to see a greater focus on liquidity. We all saw in 2022 the dangers of having too many of your assets in illiquid mandates.

So it's really important that schemes ensure they have sufficient liquid assets. So these three areas in light green were deemed to have improved since 2022, but they also identified two further areas in orange where there's room for improvement. Firstly, they encourage schemes to test resilience in adverse market conditions and specifically testing the ability to restore buffers within five business days. And that includes the time it takes to make any decisions, instructions that need to be sent, and then the settlement of any assets that are sold. So this is an area where delegation can be really valuable. And finally, they looked at the diversification of collateral assets. Trustees should aim to diversify the collateral assets given the risks and the stress event. So the review made one thing clear.

While schemes have made real progress since 2022, there is still room for improvement. So the natural question is, what does good look like in practice on what are our clients doing? How are they already taking action? So first and foremost, the design of the collateral waterfall, by which I mean the overall framework that scheme has in place to top up collateral. Typically, this includes certain rules or parameters that govern what actions are taken if collateral buffers reach particular levels. For example, if my buffer falls below 4%, do X. If my buffer falls below 3%, do Y, or if my buffer rises above another level, do Z. So looking at waterfall parameters, you want to set these trigger levels far apart enough to avoid constant whipsawing in and out of funds, which would mean incurring higher transaction costs.

And so having little chance of making money from the investments in the funds. Next, does your framework include discretion to act differently in different market environments per regulator's guidance? Because sometimes you have a plan, but it might not always be appropriate. You can't plan for every eventuality, so you need to have capacity to deal with the unknown unknowns. And also at the other end of the spectrum, might you actually be sitting on too much cholesterol? Could this be invested in something else to improve efficiency as well as considering resilience? And that's something we've seen some of our clients do recently. Next we look at a client's ladder of collateral waterfall assets.

Clients can use a range of funds with a mix of liquidity profile and different risk and return characteristics depending on their requirements. Trustees often choose asset-backed securities as a suitable asset for backup collateral, given they are floating rate and low credit duration, which means they're less likely to have lost value when you need to sell. And they're also highly liquid. But also trustees are looking to diversify this mix so that there's less reliance on a single asset class. And for this, you want to have something that has a low correlation with other asset classes, such as an absolute return bond fund, which doesn't have systemic market exposure. And finally, can you transform your corporate bonds into collateral via credit collateralization so that you can improve your collateral buffer without having to sell anything? There are a couple of ways to do this, including trading repo and corporate bonds as well as collateral upgrade trades that allow schemes to post corporate bonds as collateral and receive cash if yields rise. The final section covers other risk management strategies that often share the same collateral pool as LDI.

So what other risks do schemes ask us to manage? The main ones are equity, currency and longevity. It's efficient to do it this way because it's capital efficient. To have all these risks supported by a single pool, you have oversight over all of them and they can all share the same documentation and infrastructure. So starting with equity, having synthetic equity rather than holding physical equities can improve collateral resilience and also downside protection has come back into focus given where equity markets are and also with schemes looking to protect the surplus next currency, most schemes, hedge non styling exposures. Doing this centrally avoids having a cash drag at a fund share class level. You can also consider your hedge ratios are these static or dynamic. Some of our clients prefer our dynamic approach as it smooths operational cash flows they need to pay to settle their FX roles.

And finally, longevity. For most schemes, this is now their largest remaining hedge risk hedging with collateral swaps needs collateral just like other derivatives in the LDI portfolio to integration into the LDI framework matters and swaps also more capital efficient than doing a buy-in. So we'll have a look now at how longevity risk alone can knock a plan of course. So in this case study, consider a scheme that's not yet fully funded on a buyout basis in investing 50 / 50 in gilts and credit, leaving longevity risk un hedged by hedging interest rates and inflation and aiming for a 100% funded in 20 years. Now the scenario on the right shows in year five, life expectancy as assumptions increasing by around one year, which immediately reduces their funding level by 3%. And the result of this is that the current investment strategy would not generate sufficient returns to reach buyout in year 20 to stay on track that either need to re risk the investment strategy to hold 75% in credit or require further sponsor contributions. So longevity is a very real risk, which can throw a scheme off track, if not hedged. So that's why you should hedge longevity.

But why hedge longevity now in particular? Well, first of all, we've seen that fees for longevity protection have come down significantly. You can see here from the chart on the left, the indicative risk of longevity swap risk free of a longevity swap has fallen from around 7% to around 2%. And that's due to two things. Firstly, high interest rates and secondly, more competition. So hedging longevity now is cheaper than it's ever been in the past. Putting on a longevity swaps was still very expensive to implement and very complex. So really only considered by the very bigger schemes.

But we've been developing a new, more efficient approach, which is a standardized derivative contract between the scheme and the reinsurer that uses the same infrastructure as our existing rates in inflation swaps. We estimate that this could cut implementation time and upfront costs by up to 75% and cut ongoing costs by around 50%. So watch this space. The longevity market is evolving fast. So to summarize, here are nine different areas for schemes to consider as part of their LDI Health Check, all of which can make a material difference in your chances of reaching your funding goals. Looking across hedge design, collateral management, and the management of other risks, the key trends we've seen in these areas include increased delegation, be that through management of inflation, caps and flaws, discretionary hedge management or collateral waterfalls, increased diversification of collateral assets, and increased focus on other risks, equity, currency, and longevity. Thank you for listening. If you have any questions, please contact your insight representative.