Your scheme is bespoke… why isn’t your LDI solution?
Liability Driven Investment (“LDI”) has become an increasingly important part of pension funding, with over half of UK pension schemes liabilities now hedged using LDI1. The typical trend in this market is that larger schemes used segregated LDI and smaller schemes (and even medium-sized schemes) use pooled funds. The focus of growth is expected to continue to shift towards pooled funds as more and more smaller schemes enter the market. However, pooled funds come with compromise and offer less flexibility and efficiency than segregated LDI. We believe all schemes, irrespective of size, should be able to access the best ideas and innovations without constraint. That’s why all of our clients have access to segregated LDI mandates and the associated benefits.
With an average segregated LDI mandate size of £1.3bn2 it is clear that this solution is favoured by larger schemes. This infers that when size isn’t an issue this is the better option. But why is that the case and what benefits does segregated LDI bring – if segregated LDI is so great, then why is pooled LDI more prominent? The answer is simple, in that the latter is easier for managers to implement as everyone gets put into the same pooled funds. We all know that every scheme is different and so a pooled approach is not necessarily in a client’s best interests. Therefore we wanted to set out here all of the aspects of segregated LDI that pooled fund investors may be missing out on.
The major benefit that pooled LDI investors miss out on is the flexibility and efficiency benefits offered by a segregated approach. This efficiency can translate into material benefits for the pension scheme. Very crudely, a segregated mandate can mean more assets invested in growth assets as fewer assets are locked up in LDI. As a result, the growth assets are not reliant on heroic expected return assumptions to compensate.
The ability to use segregated LDI can allow a scheme to target up to 1% extra in return while maintaining the same hedge level. This a) brings forward the expected time horizon to being fully funded and b) reduces long term sponsor reliance, which are material benefits.
This flexibility to generate more return is further enhanced by utilising additional tools offered by the segregated approach. These tools include structured equity, currency hedging and swaptions to name but a few. Structured equity mandates, which allow equity-like returns with downside protection, can be efficiently implemented under the same arrangement. Having the flexibility to access these additional tools is something we use to a great extent and offered fantastic opportunities over the last year.
The final point that’s increasingly relevant for maturing pension schemes is accuracy and flexibility around the design of the liability hedge. Although important, it is secondary to the points above. Given the size of the risk that interest rates and inflation pose to pension schemes, using pooled LDI to crudely hedge the risk, can still leave schemes exposed to more volatility than they might like. Having the ability to more accurately allow for inflation, for example, is particularly relevant given the recent RPI consultation. We have been able to easily implement tailored hedging solutions for our clients, where this was a particular issue.
Our approach to investment management generally is to demand more on behalf of our clients and LDI is no different. It is important to deliver a best in class solution, no matter your size, as at the end of the day, it is key to improve your members’ outcomes. Don’t be forced to use pooled LDI just because it is easier for your provider to deliver!
1 - Source: XPS LDI Survey 2019
2 - Source: XPS LDI Survey 2018
This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that this communication is directed at, and intended for, the consideration of Professional clients only. Retail clients must not place any reliance upon the contents.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
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