Liability Driven Investment
5. Monitoring such a structure: Main
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5.1 There are
three key elements to the above structure that might need monitoring (other
than the usual monitoring that would be carried out even if no LDI approach was
being adopted on the return seeking portfolio):
(a) The (actively
managed) underlying bond portfolio. This would be assessed as usual for the
asset management product in question. For example, if it involved management of
a credit portfolio against a market index then performance and risk measurement
and attribution analyses versus the benchmark in question might be reported as
per the asset manager’s/pension fund’s usual reporting cycle.
(b) The (passive) swaps
overlay. This might for simplicity also be reported upon to a similar
frequency, although most attention would be focused on those occasions when the
swap positions needed to be altered.
effectiveness of the choice of swaps overlay structure in relation to the
scheme’s liabilities. Various approximations will have been interposed
between the precise liability model available from the actuary and the precise
structure of the swap portfolio. The swap portfolio being ‘execution-only’ in
nature, this element of the decision-making is actually one that lies with the
trustees, albeit only after taking advice from other parties.
5.2 The key
additional requirement is to construct some sort of liability benchmark (or
index) that reflects in a market-orientated way the nature of the liabilities.
Constructing such a benchmark may also directly guide the choice of swaps to
hold within the overlay portfolio.
5.3 The most
obvious way to proceed is first to develop some cash flow projections,
differentiating between ones with different sorts of economic sensitivities
(particularly those where the sensitivities have option-like characteristics,
such as LPI). For example, the liability flows might be differentiated by year
of projected payment into those that involve:
(a) Fixed monetary
sums, e.g. those arising from benefits not subject to any increases.
(b) Fully RPI
inflation-linked sums, e.g. benefits subject to full RPI linked increases.
(c) Sums that
increase on a year by year basis on some more complicated measure driven by
inflation at that time, e.g. LPI-type increases in payment. For these sorts of
liabilities, the expected outgo during a given future year can still be derived
from a single expected amount at outset, together with the history of RPI
increases since then. If different ceilings, say 2.5% and 5% pa caps, apply
then these flows should in principle be differentiated, as swaps to match them
exactly would also differ.
(d) Cash flows governed by
more complex increase formulae dependent on multi-year investment or economic
conditions. At least in principle, benefits linked to LPI in deferment fit into
this category. The big difference between these sorts of cash flows and the
sorts referred to in (b) or (c) are that they in principle require
multi-dimensional matrices to specify as they depend jointly on date of
withdrawal, assumed date of retirement, assumed date of payment and (for those
already deferred pensions at outset) on how large RPI increases were prior to
the start of the projection relative to the caps and floors present in
individual members’ benefits. As with (b) and (c) they also depend on RPI
increases post the start date of the projection.
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