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Publication

Professional Pensions

Date

22 July 2015

How the evolution of LDI could hinder buyouts

LDI has been a helpful tool for schemes looking to de-risk. But does the emerging use of illiquid
assets mean LDI could become a hindrance to achieving buyout? Stephanie Baxter investigates.
Since its beginnings in the early 2000s, liability driven investment (LDI) has grown into one of the
most popular de-risking strategies for UK defined benefit (DB) schemes and, concerned about the
divergence of assets and liabilities, schemes of all sizes have embraced LDI as a tool to manage
funding levels.
KPMG's annual survey on the UK market has revealed 2014 was a bumper year with more than 200
new mandates and a 29% increase in LDI assets to 657bn.
LDI, which essentially involves investing in a portfolio of assets that has a similar profile to all or
part of a scheme's liabilities, has evolved considerably over the past decade. Portfolio construction
has developed from simple buy-and-hold physical gilt-based strategies to include synthetic and
multi-asset components. Derivatives, from vanilla swaps to the more exotic instruments, have been
increasingly used to manage interest rate and inflation risk, duration and funding volatility.
Implications for buyout
Logically, schemes opting for an LDI strategy - which represents a partial de-risking - are likely
candidates for a full or partial buyout in the future. The closer a scheme gets to becoming fully
funded the less risk it needs to take so many schemes would have invested in gilt-based LDI as a
stepping stone to this ultimate goal.
"For a scheme looking to go down the buy-in or buyout route, an LDI strategy becomes even more
critical," says BlackRock client solutions managing director John Dewey. "You need to plan, and
ensure that you have the right assets and funding level to be able to lock in the price from the
insurer."
LDI is helpful in moving towards buyout if it utilises assets that insurance companies would want to
hold, or are liquid enough to efficiently convert into such assets. This has given rise to so-called
buyout aware' products but these can be expensive as gilt yields are so low.
The illiquidity premium
LDI managers have reacted to the high price of gilts by creating products that aim to match
liabilities while generating significantly stronger returns.
Many of these involve capturing the illiquidity premium. This means achieving higher returns that
not due to accepting greater risk per se but because exiting and valuing the investment is more
problematic. Alternative or illiquid credit strategies, for example, produce income that can help
mitigate investment risk elsewhere in the scheme's assets. For example alternative credit could be
used to cover pensions in payment while the rest of the scheme's assets are invested more
aggressively.

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Buck Consultants senior investment consultant Celene Lee explains: "If a scheme is still holding
equities it is not forced to sell them while market values are down. That's quite useful considering
the events seen in the past few months."
Dewey says BlackRock is seeing "significant interest" in infrastructure, mortgages, real estate and
direct lending. Likewise, Aon Hewitt senior partner John Belgrove says equity release mortgages,
commercial loans and secured lending to banks have started to come inside LDI arrangements.
The value of liquidity
Investors only earn enhanced returns from sacrificing liquidity because liquidity has real value - and
trustees should be very cautious about the effects of forfeiting it, which will vary from scheme to
scheme.
"Some schemes can bear illiquidity - if they have a very long-term horizon and are not targeting a
buy-in or buyout," says Dewey. "If they're targeting a buyout or have a relatively weak sponsor, they
may want to focus on more traditional liquid assets."
Schemes also need to realise that a very illiquid form of LDI could be a barrier to a buyout. As PTL
managing directorRichard Butcher explains: "Trustees must be mindful that they need to have
liquidity in order to transact. They either need to be aware of liquidity or be aware of the ability to
trade the asset [elsewhere]."
The risk for schemes is they find that, when they wish to conduct a buyout, they either cannot find
a buyer for the illiquid asset or can only do so at a price substantially below what they expected.
As, by definition, there is no real-time market to constantly provide prices for illiquid assets,
pricing may move far away from expectations - and the risk is substantial for very illiquid assets
such as small issue infrastructure debt with a long maturity. In such cases, the scheme would either
have to realise a loss or give up on the idea of buyout.
In specie transfers
One potential way to avoid realising losses on illiquid assets would be to conduct an in-specie
transfer which involves transferring assets rather than cash to the insurer. However, such a transfer
would depend on the insurer's appetite for illiquid assets in general and the specifics of the assets
held - and the insurer would value the assets itself, ignoring what the scheme actually paid for
them. Such transfer and valuation processes would take time and resources and the insurer would,
of course, impose a haircut on the value of the assets for its trouble.
Schemes ultimately targeting buyout should therefore be confident the assets proposed for an LDI
strategy would be acceptable to insurance firms - in various market conditions including times of
stress.
Butcher says: "If you plan ahead and well enough, you can create a portfolio of illiquid investments
that you know the provider will take off your hands. Schemes can trade illiquidity but they need to
liaise with the insurer to see what they will be willing to take on."
To maximise the chances of multiple insurers putting in competitive bids for LDI assets they should
ensure they are as deep as possible within insurers' comfort zone. It is crucial to bear in mind that
the bread and butter of insurance company investment is government and corporate bonds. It is
unlikely they will have the desire or ability to value over-the-counter securitised banking products.
Therefore, to minimise this risk the scheme's LDI (and other) investments should be aligned with
those of the insurer. "If schemes are getting close to buyout and trying to reduce their relative risk,

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they could buy exactly what the insurer wants them to buy because then the relative risk reduces
to zero," according to Butcher. Products are being created to track and mirror insurers' prevailing
asset structures so schemes can just tip straight into an annuitised arrangement.
Selling illiquidity
Proponents of illiquidity in LDI portfolios argue that insurers have been investing in more illiquid
assets in recent years, such as infrastructure debt and mortgages.
"Historically, insurers tended to only want very liquid government bonds and high grade credit
instruments - but that's changing with the search for extra yield," says Belgrove. "With yields and
credit spreads as low as they are, insurers have moved towards less liquid opportunities in search of
enhanced return."
This trend is also gaining momentum as insurers are rewarded for diversifying their assets pools
under the EU Solvency II regime.
Insurers have also increased their appetite for infrastructure projects. These can range from
gaining exposure to existing toll roads or railways to investing in the construction of the supersewer under the River Thames. Such opportunities have arisen due to Basel III increasing costs for
banks, leaving the market open for non-banks unburdened by capital adequacy considerations.
However, while an insurer may be comfortable investing in a certain exotic, less illiquid asset
classes, there is no guarantee they will be interested in any one particular asset. By their nature
the opportunities are small and esoteric and in this sector valuation is a hands-on as well as costly
process. It also requires a lot of ongoing due diligence and specialist expertise the insurer may not
be willing to do. Even though insurers do invest in these types of assets, as Dewey warns: "They
often like to source them themselves".
The willingness to accept an entire asset type can also evaporate. Belgrove says: "At the moment
there's appetite [for illiquid assets] - but who knows, that could change in the future. I suspect the
insurer would impose a haircut anyway as they can't liquidate it on a secondary market. [Schemes]
won't necessarily get the full value."
At the very least, holding illiquid assets ahead of a buyout creates additional work and uncertainty.
"It can create an extra layer of complexity at the point of trying to execute a buy-in or buyout,"
says Dewey. "We take a prudent approach and not necessarily assume insurers will take them on. If
we're looking to put in place an infrastructure, private equity or direct lending programme, we plan
for the worst case and hope for the best."
State Street Global Advisors head of LDI EMEA Howard Kearns agrees that thorough planning is
crucial when putting less liquid strategies in place. "Pension schemes either need to be in a fund
vehicle that gives liquidity or, if they're not accessing it in a liquid way, then they need plan for how
and when they can get out of it. In some cases issues are relatively straightforward to think through
but the solution is not necessarily simple. Like all good plans it's never set in stone - so keep on
planning."
Kearns says he sees a lot of schemes sticking with swaps and gilts because it is what they
understand. He says: "They want their LDI portfolio to be relatively risk free, not to bring up any
surprises and not have to worry about it too much. Those assets can hopefully move over to the
insurer. Although there might be some issues with pooled funds as insurers might not necessarily be
able to take swaps."

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Scheme-appropriate solutions
Ultimately, whether it is appropriate to allow illiquid assets to be used in an LDI strategy depends
on how close a pension scheme is to a buyout, both in terms of timescale and funding level.
Caution is advised if a scheme is mature and buyout is a real possibility in the next few years. LDI
cannot be considered de-risking if investment risk is simply replaced by illiquidity risk - and the
trustees must be certain the assets will not need to be liquidated on unfavourable terms. The
liquidity of assets is also not a constant; if the economy deteriorates what seems like an attractive
opportunity now could quickly become unsellable.
In any market conditions, insurance companies are probably not ideally placed to manage most
forms of illiquid assets. Holding them will reduce the number of insurers bidding to buy out scheme
assets and therefore increase the cost for the scheme.
If however a buyout is not on the agenda, a scheme is in a good position to capture the illiquidity
premium and can enjoy returns not available to funds with shorter time horizons. Basel III and
other regulation will mean there is a stream of banking assets available to pension funds, which
provides solid opportunities for fortunate schemes.
http://www.professionalpensions.com/professional-pensions/feature/2418773/how-the-evolutionof-ldi-could-hinder-buyouts