Liability Driven Investment

3a. The swaps element of such a structure: Clarification of who does what

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3.1          Divorcing the core physical portfolio from the derivatives overlay helps to clarify who is responsible for what decisions. The following parties are involved and would typically have the following responsibilities if LDI is being applied to a UK defined benefit pension scheme:


(a)    Trustees: Carry ultimate legal responsibility for the fund. They would be responsible for choosing who manages the core element and the swaps overlay. In the above structure, they would also be responsible for instructing the investment manager when to execute exactly what swap transaction (although in practice there would have been prior liaison with the investment manager in choosing how best to frame these instructions).


(b)   Scheme actuary: Would normally prepare any required liability cash flow projections, and update them as necessary at regular intervals. See below for what such projections might contain.


(c)    Investment consultant: Would normally advise the trustees on overall investment strategy, on fund manager selection and on how to monitor the fund manager and measure the manager’s performance. Together with the actuary would advise on exactly what liabilities to match (e.g. should it include pensions in payment, deferred pensions and/or actives’ liabilities?).


(d)   Fund manager: Likely to be responsible for managing the underlying bond portfolio and for actual implementation of the swap transactions. The role in relation to the swaps overlay could perhaps best be classified as ‘execution only’ in the sense that the fund manager would probably help draft up any instructions formally given to it by the trustees and/or investment consultant, but otherwise the swap portfolio would be ‘non-discretionary’. This would be in contrast to the core physical portfolio (which would most typically involve discretionary active management). The fund manager would most likely provide education to the trustees, views on transaction timing and valuations of the individual swaps. The fund manager would also most likely arrange for the collateralisation of the swap portfolios.


(e)   Investment bank: Would be the trustees’ actual swap counterparty, i.e. the entity whose balance sheet would honour the contractual obligations in any given swap transaction. In principle, trustees (or their consultants) could deal directly with such banks (subject to any overriding requirement on the trustees to avoid ‘day-to-day’ investment activity if they are not FSA regulated). But in practice, banks’ derivatives desks are remunerated on a transaction-orientated basis. This is not obviously conducive to acting in the best interests of the trustees. It is most likely that the trustees would delegate choice of swap counterparty to their fund manager, who would make the choice by reference to the usual sorts of ‘Best Execution’ criteria that apply to fund manager dealing activity (subject to any overriding criteria set by the trustees such as a credit rating requirement). There could be several such banks, as the fund manager in principle needs to apply Best Execution criteria each time new swap transactions take place.


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