Liability Driven Investment
3b. The swaps element of such a structure:
Practical considerations
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3.2 In practice,
there is likely to be close liaison between the actuary/investment consultant
and the fund manager when preparing suitable liability projections and hence a
proposed structure. The fund manager might also typically work with a few
well-chosen investment banks who can help to identify what derivatives are most
likely to meet the client’s requirements.
3.3 There needs
to be such interaction because overly exact cash flow matching might result in
an overly complex (and therefore expensive) structure, bearing in mind the
inherent approximations involved in liability projections (and the inherent
approximations involved in modelling how the actively managed core portfolio
might behave). There are also minimum amounts below which it is impractical to
effect swap contracts, which depend in part on how non-standard the swap is.
An exact hedge of all of the risks embedded in the liabilities may be
prohibitive or even impossible (e.g. liability driven ‘investment’ has rarely
to date attempted to include scheme-specific longevity protection). Experience
suggests that complicated overlay structures may initially be discussed with
trustees and their consultants, but typically only relatively simple structures
seem to be used in practice.
3.4 At regular
intervals (say yearly) the client (in conjunction with its actuary/investment
consultant) would probably revise its cash flow projections and, after
discussion with the fund manager, would instruct the fund manager to alter the
structure of the swaps within the swap portfolio. Again this would be done
subject to the usual Best Execution rules, perhaps if necessary novating or
cancelling previous swap transactions with new ones (to avoid building up large
numbers of swap transactions that largely cancel each other out and which might
be burdensome to administer).
3.5 This flurry
of activity at outset contrasts with what happens the rest of the time. The
fund manager does incur some ongoing costs, most notably the costs of sorting
out the collateralisation of the swaps, as well as ongoing reporting/valuation.
These costs are typically smaller than the costs of actively managing a
portfolio, and might be absorbed within an all-in fee covering both
arrangements. It would be possible for the fund manager of the swaps overlay to
be different to the fund manager of the underlying physical bonds (just as a
scheme’s tactical asset allocation manager does not need to manage any of the
underlying assets). However this may make collateralisation procedures more
complicated.
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