Liability Driven Investment

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Liability Driven Investment - does it really
help?
Chris Johnson LGC Seminar 6th November 2006
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Many different LDI solutions, each promising to
wash whiter.
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But someone thinks theres gold in them thar
hills

• Vehicles created to buy out corporate pension
  schemes
• Goldman Sachs (Addy Loudiadis)
• Paternoster (Mark Wood, ex-Prudential)
• Pearl Group (Hugh Osmond, ex-Pizza Hut, Punch
  Taverns etc)
• Pensions Insurance Corporation (Ed Truell,
  ex-Duke Street Capital)
• Synesis Life (Isabel Hudson, ex-Prudential)
• Most backed by Private Equity funds in which
  many Pension Schemes invest..
• Prospectively also, life insurers such as Aviva,
  Aegon, LG

Source Financial Times 28/9/06
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Why all the fuss now?

• The cult of equity in the early 1950s derived
  from a concern to match the real value of
  liabilities.
• MFR in the 1995 Pensions Act was supposed to
  encourage better liability matching
• The perfect storm of 2000-02
• Deficits
• Weakening covenant of corporate sponsors
• FRS 17
• MA, esp. Private Equity LBOs
• Impoverished pensioners, after bankruptcy of
  corporate sponsors
• 31 of corporate schemes above 776 million have
  implemented some form of LDI strategy

Source Pensions Week survey 9/10/06
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What is LDI supposed to achieve?
In an ideal world ensure that market volatility
does not threaten future pension payments - by
perfectly matching future cashflows from
liabilities
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But there are many concerns

• Deficit lock-in / loss of out-performance
  potential
• Life expectancy ever drifting upwards
• Discount rate is only an assumption
• Complexity / suspicion of concept
• Increased governance training
• Market timing
• Suspicion of high hidden charges
• Fear of swaps other derivatives
• Tensions between Trustees Sponsor

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How relevant is this to the LGPS?

• Some valid reasons in the corporate sector
• Ironic that funds with long-term liabilities must
  adopt a short-term investment horizon
• Council accounts are subject to FRS 17
• As also the increasing number of private sector
  admitted employers
• Prudent practice would encourage some
  consideration of liability matching
• Yet, one hopes that the strength of the ultimate
  sponsor covenant will enable LGPS funds to take
  an appropriately long-term investment view i.e.
  not need to fine-tune LDI to the nth degree

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Local Authorities considering LDI (Pension Week
survey 9/10/06)

• Considering will move in 10
• Considering now 24
• Considered rejected 33
• Have not considered 33

Source Pensions Week survey 9/10/06
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What about deficits?

• LGPS funds have deficit recovery periods ranging
  from 14 to 40 years
• Some complex derivative-based schemes can still
  leave scope to generate alpha, by using leverage
• There are simpler, less specific solutions,
  subject to the recognition that
• the wider the investment universe (preferably
  global, even multi-asset), the easier it is to
  generate alpha and at a better information ratio
• modern investment techniques enable alpha to be
  generated from these wider investment universes
  onto another benchmark (e.g. Gilts)
• the easiest way to do this is to use a total
  return swap, under which LIBOR is exchanged for
  the return on the desired index but this is
  still a grey legal area in the minds of some LGPS
  funds

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What solutions are open to LGPS funds?

• Go for a detailed ALM solution like a corporate
  scheme, using derivatives, maturity bucket funds
  etc, but leaving some scope for out-performance
• Take a longer-term, less specific view
• Select a benchmark which is a reasonable proxy
  for their liabilities (say, over 15 year ILG
  and/or over 15 year Gilts, or maybe 3-month LIBOR
  or RPI)
• Determine the out-performance target risk limit
  (say, 5 Value at Risk)
• Determine the appropriate investment universe
  (global bonds can usually generate up to 2
  alpha higher targets need to include equities)
• If they are happy to use total-return swaps to
  overlay alpha onto benchmark, seek an LDI-Plus
  manager for above
• If not (or amount lt 100 million), seek pooled
  fund(s) of said profile

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So, can LDI really help?

• No in that the strength of the LGPS employer
  covenant may not make the more complex structures
  appropriate
• But, yes, in that it is imprudent to be
  complacent and ignore some of these solutions
  which can provide greater stability of returns,
  relative to liabilities

• An expensive tailor-made solution may not suit
• Some stores use the best ideas from the catwalk
  to design a perfectly acceptable and more
  affordable range for those who do not need to
  wear Dior every day

Marks Spencer Autograph double velvet stripe
dress
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Disclaimer
Issued by Crédit Agricole Asset Management (CAAM)
London Branch, which is authorised by the
Autorité des Marchés Financiers and regulated by
the Financial Services Authority for the conduct
of investment business in the United Kingdom.
This report is for information purposes for
professional investors only and is not intended
as an offer or solicitation with respect to the
purchase or sale of securities. Opinions and
estimates may be changed without notice. It may
not be copied or distributed to any other person
and must not be distributed to private customers
in the UK. Investment in the fund should be made
on the basis of the current Prospectus which is
available from Crédit Agricole Asset Management
(CAAM) London Branch, 41 Lothbury, London, EC2V
7HF. The past performance of investments is not
necessarily a guide to future returns. Changes
in rates of exchange and other factors may cause
the value of an investment to go up or down.
CA Funds Gilt Plus (GBP) and Index-linked Plus
(GBP) Crédit Agricole Funds is a Luxembourg
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Investment in the fund should be made on the
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Prospectus or Simplified Prospectus for the
relevant sub-fund, which are available from
Crédit Agricole Asset Management (CAAM) London
Branch, 41 Lothbury, London EC2R 7HF, telephone
020 7074 9332.

• Contacts at CAAM London Branch
• Ian Milton 020 7074 9330 ian.milton_at_ca-assetmana
  gement.co.uk
• Chris Johnson 020 7074 9331 christopher.johnson_at_
  ca-assetmanagement.co.uk