Sorca Kelly-Scholte
Institutional investors who often pursue liability driven investment with rigid barbell allocations to growth and hedging asset buckets are falling victim to a blinkered form of mental accounting, which many can ill afford given the rising costs of derivatives insurance and today’s incredibly low Gilt yields.
Put another way, pensions who are more realistic – willing to acknowledge the configuration of their end-game portfolio may be closer to a mix of corporate bonds credit and real assets than to a pure Gilts portfolio – are poised to realise profound cost savings.
LDI as a concept has been refined to the point of commoditisation, with a resulting perceptual narrowing on the part of the industry as to how to best organise assets against a defined set of liabilities.
UK pensions anchored on gilts when they started utilising mark-to-market accounting in the last few decades, leading to a sort of idolising of LDI. By using the gilts proxy as a benchmark, pensions implicitly focused primarily on funding level volatility as the key measure of risk. That in turn led to enormous effort and resource being expended to manage down that volatility, with many schemes dividing their portfolios strictly between ‘growth’ and ‘matching’ buckets, with the matching bucket dedicated to the purest possible liability hedge and the growth bucket driven to maximise total returns.
Sadly that practice has tended to leave large swath of assets effectively orphaned. Assets that neither match the liabilities perfectly nor offer equity-like levels of return can struggle to find a home. Glide paths typically aim to shift assets from growth to matching as funding levels improve, ensuring that the allocation to the matching bucket is maximised. In the name of pursuing increasingly rigid barbell strategies where the allocation to the matching bucket is maximised and the growth bucket is juiced up as far as possible, schemes end up dramatically underutilising securities that exhibit characteristics of both.
There’s another problem in practice for LDI – it embeds an assumption that the target portfolio at the end of the de-risking path is a Gilt portfolio. In reality, however, most schemes define self-sufficiency as being able to run the scheme off and meet liabilities as they fall due without recourse to the sponsor. In other words, securing cash flows at a reasonable price with acceptably low risk. Against this description, the target portfolio at the end of the glide path could look very different to that implied by the Gilts-anchored approach. Gilts certainly secure cash flow, but it is questionable whether they pass the “at a reasonable price” test when compared against other possible strategies for securing the cash flows.
Gilts are also increasingly suffering from a scarcity issue, as more and more buyers compete for fewer assets. Broadly speaking outstanding UK defined benefit liabilities are roughly equivalent to the total market supply of new issuance in UK gilts. Unfortunately pensions aren’t the only natural buyers of gilts – they are competing with insurance companies, foreign investors and all manner of other buyers. There just isn’t enough supply to go around, which is having an inevitable impact of pushing up prices at the long end of the curve. There is definite evidence of resistance levels – at any time there has been an uptick buyers have come out the wings to take advantage of lower prices, limiting any further rise.
We would argue for pension schemes that the game must evolve – it has to be more about assessing your cash flows than about a purely theoretical take on LDI. We challenge the notion that the means of measurement should narrowly define the means of investing. Bringing into view a more targeted self-sufficiency portfolio focused on meeting cash flow needs would encourage trustees to start building that portfolio earlier and funding the long-term positions as opportunities become available, rather than waiting to make a big bang transition at some point in the future.
The “Gilts-plus” formulation has certainly moved us on from the heavily smoothed valuation approaches of yesteryear, and to make the leap from the asset-only to the asset-liability perspective in managing pension assets. Nonetheless, in a lower for longer world, we need to be more thoughtful about how we define the benchmark, or target, portfolio, whether implicitly or explicitly. Looking at our capital markets today, that means changing the anchor from Gilts to a broader set of core cash flow matching instruments, and building more balanced long-term portfolios.
Sorcha Kelly-Scholte is Head of EMEA Pensions Advisory Solution at JP Morgan Asset Management.
