Liability Driven Investment
1a. Introduction: Material covered
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1.1 There is
growing interest in the concept of liability driven investment (‘LDI’)
for many types of institutional investor across many different locations.
Liability driven investment is commonly adopted by life insurance companies
(although they may not use this term) for liabilities which contain guarantees
or underpins, and by defined benefit (‘DB’) pension schemes. Indeed, it can be
argued that every institutional investor to some extent bears in mind
its liabilities when formulating its investment strategy – few investors have no
liabilities at all which they wish to honour!
1.2 In these
pages we will mainly focus on LDI as applied to DB pension funds (and to a
lesser extent insurance companies), although we will also from time to time
refer to LDI applied to other types of institution. Large mature DB pension
schemes with a greater bond focus typically seem to be more interested in this
type of investing than less mature more equity focused clients.
1.3 There are
several different ways in which a liability driven investment portfolio might
be structured. Perhaps the simplest involves two or three parts:
(a) A return
seeking portfolio (typically actively managed), invested in those asset
classes and vehicles the investor believes have the highest likelihood of
outperforming without carrying undue risk.
(b) A protection
portfolio involving investment in physical securities, often bonds, chosen in
broad terms to have economic characteristics that mimic those of the relevant
liabilities. For example, if the liabilities are partly fixed in monetary terms
and partly linked to inflation, i.e. to movements in a Consumer Price Index
(CPI), then it might incorporate some fixed interest and some inflation-linked
bonds.
(c) A swaps
overlay (or more generally, a derivatives overlay) portfolio. This
would typically consist of one or more swap contracts (or other similar
derivatives) that involve the pension fund giving up one set of future cash
flows (e.g. ones like those arising from the portfolios in (a) or (b)) and
receiving in return another set of future cash flows (e.g. ones more closely
matching the relevant liabilities). Precisely how these swaps might be
structured can vary. For example, there might be one swap that pays away to the
swap counterparty cash flows akin to those arising from the portfolio in (a) or
(b) in return for interest payments on some notional principal linked to
prevailing cash rates (e.g. LIBOR). There might then be a second swap that paid
away this LIBOR cash flow in return for a cash flow that more closely matched
the pension fund’s expected liability outgo. Or there might be several swaps on
each side that handled different parts of the cash flow (e.g. differentiating
by term or by liability type). Or, all of the cash flows might be wrapped up in
a single overarching swap.
1.4 Usually,
investors seek a balance between risk and reward, hence the existence of the
return seeking element as per (a). The relative size of the return seeking
portfolio versus the protection portfolio/swaps overlay (or to be more precise
the relative sizes of the exposures within them) will depend on where within
the spectrum of possible alternatives the investor wishes to pitch this
balance. Investors may, for example, believe that there is an intrinsic
likelihood of long-term outperformance associated with a particular type of
asset, e.g. equities (e.g. because a capitalist economy ‘ought’ over the longer
term to reward entrepreneurs and hence to reward equity holders more than those
who bear less risk of loss from business failure). However, investors may not
be willing (or may not be allowed the latitude under regulation) to invest
their entire asset base in return seeking assets, even in a diversified
portfolio of such assets, because of the risk that the asset performance might
be worse than expected. If the investor is subject to mark-to-market regulatory
principles (and Kemp
(2009) argues that there are good reasons why governments should want most
investors to be subject to such rules, if suitably defined, even if this is not
always the current position) then ‘performance’ here may not relate merely to
the behaviour of the assets between purchase and maturity but also to their
market value movements in the meantime. Investors not interested at all in LDI
can be viewed as a special case of the above, where their entire portfolio is
held in (a).
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