Segregated LDI mandates: the ability to tailor
Many people will point to the key benefits of a segregated mandate as being the accuracy that comes from knowing the exact liabilities that a pension fund has. At River and Mercantile, we believe it is a side benefit.
Many people will point to the key benefits of a segregated mandate as being the accuracy that comes from knowing the exact liabilities that a pension fund has. At River and Mercantile, we believe it is a side benefit. The key benefits are those outlined already in weeks two and three of this series where we discussed greater efficiency and the ability to use additional tools. However, although accuracy and thus the ability to tailor LDI is a side benefit, it is an important one.
With a segregated LDI mandate, the manager looks at the liability cashflows and all their nuances, as provided by the client. A pooled fund will manage against an average “profile”.
This is more important today than it was 10 years ago for a couple of reasons:
1 - Benefits are more complex today and a segregated mandate can take all of the nuances into account.
Even the smallest schemes now have a number of different caps and floors with the inflation-linkage. The question of how to deal with RPI vs CPI benefits is also more important now than it was in previous years. A segregated mandate means that all of these effects can be taken into account when managing the mandate – for example, caps and floors can automatically be adjusted for in benchmark calculations and the portfolio updated accordingly without intervention or monitoring from Trustees and Consultants. As well as being more accurate this means that fewer updates to the benchmark will be needed when compared to a “profile” LDI fund. Allowing for CPI benefits and RPI reform risk is also possible in a bespoke segregated mandate. For example:
- Underhedging CPI cashflows
- Different hedge ratios by term
- Implementation of CPI swaps on a bespoke basis.
2 - Cashflow and meeting of cashflow has also become important for clients
Whether this manifests itself in simply working out where to source disinvestments or in the implementation of a Cashflow Driven Investment (CDI) strategy, the bespoke nature of a segregated mandate means that all of this can be dealt with easily. Regular cash requirements can be built into the mandate and if required, the portfolio can be built in a way to meet them. Additionally, if a client implements a CDI cashflows matching mandate (whether internal or external) this can be taken into account in LDI modelling. Whilst this is still possible when implementing LDI on a pooled basis, all of the responsibility lies with the Trustees leading to a higher time/cost commitment.
“...it becomes clear that segregated mandates can be managed in a way that totally focuses on the individual scheme’s requirements – something that simply isn’t possible in a pooled arrangement. ”
Altogether therefore, stepping back even further, a segregated mandate has full flexibility to tailor the implementation to each individual client and their needs:
- Trigger points are easily implemented without additional cost
- Individual portfolio information is available for each client so can be fed into bespoke reporting systems
- Execution timing is fully flexible with no dealing deadlines or pressure.
When you add into this the additional flexibility of the tools we discussed in Week 3, which in essence also lead to bespoking of mandates, it becomes clear that segregated mandates can be managed in a way that totally focuses on the individual scheme’s requirements – something that simply isn’t possible in a pooled arrangement.
Glossary of key terms
Segregated mandate – an LDI mandate where the client has their own set of derivatives direct (through an LDI manager) with the bank
LDI Pooled fund – here we mean leveraged pooled funds with multiple investors where £100 of hedging is achieved by investing less than £100 in a pooled fund
Equity-linked LDI pooled fund – As above but the amount invested in the pooled fund is also exposed to equity movements (through futures)
Collateral – collateralisation is the movement of assets between the parties of a trade to manage counterparty risk. The aim of the process is to ensure that the entity with the positive value of derivatives has the same value of collateral (typically gilts or cash) posted from the other side
Collateral pool – as the collateral process is two way the pension scheme/pooled fund must hold a pool of assets to be comfortable that it can meet the collateral requests from the counterparty if the derivatives are negative
Leverage – we mean that the amount of hedging is greater than the size of the collateral pool.
LDI Trigger points – a defined point, usually based on either market conditions (such as levels of interest rates) or the schemes funding position, where pre-agreed increase in LDI will take place.
This article has been issued and approved by River and Mercantile Derivatives, a division of River and Mercantile Investments Limited, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority. Please note that all material produced by River and Mercantile Derivatives is directed at, and intended for, the consideration of professional clients only. Retail clients must not place any reliance upon the contents.
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