1 For a more in-depth analysis of the science of LDI and the accompanying governance considerations, please see: The Trustee Guide to Investment. Andrew Clare and Chris Wagstaff. Palgrave Macmillan. 2011. Chapters 6, 12 and 15.
2 The introduction of mark-to-market accounting in November 2000 meant that DB scheme asset values were no longer actuarially smoothed on a triennial basis, to eliminate the effect of short-term asset market volatility, but valued annually at market value, thereby capturing this volatility. Simultaneously, DB liabilities were valued, or discounted by, the AA corporate bond yield, rather than the previous methodology of effectively employing the, much higher, historic rate of return from equities. Combined, these two measures, in one fell swoop, gave rise to gaping DB deficits.
3 Members can typically commute part of their pension for a cash sum, take early or late retirement and sometimes exchange their pension’s index-linking for a larger initial pension (under a Pension Increase Exchange exercise).
4 So, if £100 is payable in one year’s time and the one year market yield is 1.5%, then the value of that liability today is £100/1.015 = £98.52, i.e. if £98.52 is invested today at 1.5%, it will be worth £100 in a year’s time. However, if the one year market yield falls to 1%, then the value of that £100 liability today increases to £100/1.01 = £99.01.
5 Given the convex (curvy slope, or non-linear) inverse relationship between bond yields and bond prices/liability values, bond duration/liability PV01 numbers change, often markedly, with material yield rises and falls, especially in today’s ultra low yield environment, where the curvy slope relationship is at its steepest.
6 The PV01 of a scheme’s liabilities is periodically calculated by the scheme’s investment consultant, to gauge the liabilities’ sensitivity to yield changes and whether the scheme’s liability proxy and LDI portfolio remain appropriately aligned.
7 Ditto IE01 for changes in market-derived expectations of inflation.
8 Before April 1997 there was no general obligation on DB schemes to increase pensions in payment (although there was a requirement on schemes that were contracted out of SERPS to provide indexation capped at 3% on rights accrued from 1988). Despite this, many schemes did voluntarily apply some form of inflation protection to pensions in payment and many applied Limited Price Indexation (LPI) retrospectively to service before 1997. However, there are statutory minimum requirements on DB schemes to: index pensions in payment in line with inflation, capped at 5% for benefits accruing from service between April 1997 and April 2005 (LPI 0,5) and at 2.5% for benefits accruing from April 2005 (LPI 0, 2.5) and revalue the deferred pensions of early leavers in line with inflation capped at 5%, and at 2.5% for rights accrued on or after 6 April 2009. There is nothing to prevent schemes from making more generous arrangements through their scheme rules. In 2012, the measure of prices used for setting the statutory minimum increase each year switched from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI). However, many schemes had RPI hardwired in their rules.
9 What constitutes an acceptable price is subjective. Some schemes set specific nominal or real yield trigger points, often based on historic nominal or real yield levels, before increasing their LDI hedging.
10 As the Bank of England, the UK’s operationally independent Monetary Authority, is mandated by the UK Government to keep the rate of Consumer Price Inflation (CPI) at 2% in the medium-term, this anchor means that inflation, interest rates and bond yields will tend to cycle around a stable level over time. Although movements in these variables will cause DB scheme liabilities to periodically rise and fall, assuming these risks over the long-term will be of no obvious benefit to the scheme. By contrast, assuming so-called rewarded risks, such as the equity risk premium attaching to equities, should benefit the scheme over the long-term.
11 Launched in 1981, index-linked gilts are generally issued with very long-term redemption dates and link the ultimate capital redemption value and semi-annual interest payments to the RPI, albeit with a short time lag. However, from 2030 this (statistically flawed) RPI linkage will be replaced by the, less generous (but statistically superior), Consumer Price Index including housing costs (CPIH).
12 Break even inflation is the market-derived rate of inflation that results from subtracting the nominal yield of a conventional fixed interest bond of a particular maturity from the real yield of an index-linked bond of the same
maturity. So, if the former has a nominal yield of 1% and the latter a real yield of -3%, then the break even inflation rate is 4%. If a bond investor expects this rate of inflation to prevail over the term of each bond, then they should be indifferent between which of the two bonds they invest in.
13 Swaps are over the counter (OTC) derivatives, so are not traded on a regulated exchange. Instead their terms are negotiated by market standard (ISDA) documentation between two counterparties – in this case an investment bank and a pension scheme. Daily movements in the resulting contracts are settled via daily transfers from the counterparties’ respective collateral pools.
14 A gilt TRS is an OTC derivative, similar to a swap, but which pays both the capital and income return from a specific gilt and has a relatively short term to maturity.
15 SIAs include long lease real estate, social housing, social infrastructure debt and ground rents.
16 For example, in November 2021, only £1.1bn was raised from the sale of an ultra long dated index-linked gilt maturing in 2073 (with a record-low real yield of -2.3883%, meaning investors will receive a return 2.3883% below the prevailing rate of retail price inflation). To put this into context, collectively UK DB liabilities are estimated by the Pensions Protection Fund (on its s.179 valuation basis) to be almost £1.7 trillion (£1,700 billion). See: The Purple Book 2021. The Pension Protection Fund. December 2021. p.7.
17 What constitutes acceptable collateral between the counterparties is documented in a Credit Support Annex (CSA).
18 The z-spread is the difference in the yield offered by gilts, or index-linked gilts, as compared to swaps of the same duration. A positive z-spread arises if gilts or index linked gilts yield more than swaps of the same duration and visa versa. Analysing the z-spread between swaps and gilts/index-linked gilts allows judgements to be made on relative value opportunities.
19 See: Global Pension Risk Survey 2021/22. UK survey findings. The DB pension risk management journey. Aon Solutions UK Limited. 2021. p.26.
20 Not all DB schemes have a single hedge ratio for their rates and inflation, though the percentage differences are usually minor.
21 According to investment consultant, Aon, 74% of DB schemes surveyed have hedge ratios above 80% of assets, with almost half of these schemes running hedge ratios greater than 100% assets. Additionally, 44% of DB schemes surveyed had increased their allocation to LDI over the past two years. Of the survey’s 137 respondents, 63% had assets at or below £1bn and 37% assets of £1bn+. See: Aon Solutions UK Limited (2021). op.cit.p.26. According to BMO Global Asset Management, Q421 on Q321, UK DB schemes increased their rates hedging activity by 27% and inflation hedging by 24%. See: https://www.bmogam.com/gb-en/institutional/news-and-insights/q4-2021-ldisurvey/
22 See: European Asset Allocation Insights 2021. UK DB De-risking Trends. Mercer LLC. 2021. p.11. This survey of c.460 UK DB schemes, with combined assets in excess of £400bn, comprises 42% of participants with assets under £100m (2% of surveyed assets), 42% with assets between £100m and £1bn (15% of surveyed assets) and 16% with assets over £1bn (82% of surveyed assets).
23 According to Mercer, over 75% of schemes with assets up to £100m or £1bn+ of assets have LDI mandates, while almost 90% of those schemes in the £100m-£1bn assets range have a LDI policy. That said, there is less appetite among very small schemes to hedge rates and inflation risks owing to governance issues and those public sector funded schemes with strong sponsor covenants that remain open to new members. See: Mercer LLC (2021). op.cit.p.10.
24 For example, take a DB scheme with £100 of liabilities, £80 of assets – both with a duration of 20 years (or a 20% sensitivity to a 1% change in yields) – and a funding ratio of 80%. If market yields rise by 1%, then for a 100% assets-level hedge, the funding ratio remains at 80% (liabilities at £80, assets at £64) but the deficit falls to £16. For a 100% liabilities-level hedge (where the hedging assets have implied gearing of 1.25 times, i.e. for £80 of assets to achieve £100 of hedging), the deficit remains at £20 (liabilities at £80, assets at £60) but the funding ratio falls to 75%. Please note: this is not investment advice.
25 In 2022, central banks are widely expected to move from the ultra accommodative monetary policies set at emergency levels since early in the pandemic, to those that recognise a normalisation of the economic backdrop – i.e. being less dependent on quantitative easing and which address the risks of allowing inflation expectations to become anchored at elevated levels.
26 For instance, the US Federal Reserve’s interest rate hikes over the course of 1994 surprised investors in terms of their timing and magnitude, causing the yield on 10-year Treasuries to rise by, a then, unprecedented, 2.2% over the year.
27 76% of UK DB schemes are now cashflow negative, i.e. with more cash being paid out than coming in, with almost all DB schemes expected to be in this position in 10 years time. See: Mercer LLC (2021). op.cit.p.6.
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