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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