Liability Driven Investment
6. Alternative approaches
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6.1 The overlay
approach described in Section 5
clearly demarcates who is responsible for what. But trustees might prefer
merely to set their investment manager a liability driven benchmark akin to the
one described above, and say “get on with it”, with the investment manager free
to use whatever instruments it likes (including swaps and other derivatives)
and whenever it likes, to match the liabilities or preferably to add value
versus them.
6.2 Key
requirements for such an approach are for the trustees and their consultants to
carefully craft an appropriate liability driven benchmark as above, for the
fund manager to have good systems for measuring at all times how far its
portfolio deviates from this benchmark and for it to be very clear exactly what
is expected of the fund manager. The bespoke nature of such a service is likely
to make it practical only for larger accounts. It is worth noting that if the
fund manager cannot practically hedge a particular part of the liability
benchmark then there will be a ‘random’ element to his performance. The fund
manager may stress this whenever he thinks it has worked to his disadvantage,
and the trustees may do the opposite whenever they think it has worked in the
fund manager’s favour. Unfortunately, there is almost certain to be
disagreement about which is the case, unless the whole arrangement is very
carefully managed. An advantage of the swaps overlay approach described above
is that it airs and manages these potential disagreements at outset, via the
discussions needed around the formulation of the swaps overlay.
6.3 The trustees
may deliberately want to adopt a strategy that deviates from the most precise
liability driven benchmark. In these circumstances, a clear liability driven
benchmark might still be defined but then deliberately modified to focus on
what the trustees want.
6.4 For example,
the trustees may feel that banks might be quoting excessive prices for buying
cash flows that embed option-like inflation characteristics such as those
implicit in LPI linked benefits. Yet they may still want some hedging of such
risks. They might then ask the fund manager to hedge these risks in a more
approximate way, using dynamic hedging, to avoid ceding this supposed profit
margin to the bank. This could perhaps most easily be achieved by giving the
investment manager a benchmark that changes in a dynamic fashion as the
underlying economic parameters change. The aim would be to mimic the economic
sensitivity of the fair value of the option-like characteristics insofar as far
as these depend on the parameters in question. A perfect hedging algorithm, were
one to exist, would of course also depend on volatility, which would require
the use of more complicated derivatives (but this would then defeat the point
of seeking to avoid the use of such derivatives because they are believed to
offer poor value-for-money).
6.5 Some
modification to the swaps overlay approach may be needed for smaller schemes. A
single swap might be easier to have ‘segregated’ in this context than a whole
bond portfolio, but there are still implicit lower limits on the sizes at which
they become practical. A better alternative may be to create specially tailored
long duration pooled bond funds. Several investment managers appear to be
designing such products. In real life, a portfolio of pension liabilities
typically gets shorter over time, so any pooled approach is unlikely to match
any particular scheme’s liabilities as well as a more bespoke approach.
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