How LDI strategies have evolved over the past 20 years

Much has changed over the past 20 years, and the world of defined benefit pensions is no exception — 2001 witnessed the birth of liability-driven investing, which has since grown to become a core component of DB portfolios.

LDI has evolved significantly from its beginning, marked by Legal & General Investment Management’s inaugural trade for Boots in 2001.

Twenty years ago, implementing LDI was complex and placed a high-governance burden on trustees. LDI strategies where highly bespoke, and only the largest schemes were able directly to enter into contracts with banks in order to gain the interest rate and inflation hedging they needed.

The overarching management of DB portfolios has also evolved. Having initially viewed LDI as a solution strictly comprising gilts and derivatives, schemes now view their objectives and the investments used to meet these from a much more holistic perspective

Huge market expansion

Asset managers, DB schemes and the market have come a long way since then, with a huge expansion in the variety of instruments used to construct LDI portfolios, improved market liquidity, and broader access for schemes of all sizes.

Given the prevalence of LDI today, it is easy to forget that is was not until 2005 that 50-year gilts and index-linked gilts were even issued, and the market continues to develop — for example, with the recent changes announced to the retail price index, and the inaugural issuance of the UK’s first ever ‘green gilt’.

The increased adoption of LDI can be seen from the chart below, where over the past five years alone we have observed clients continuing to increase both their interest rate and inflation hedging against a prevailing backdrop of low rates, rising inflation and sustained central bank support.

Hedge ratios have generally increased by around 5 per cent a year and, at the same time, the gap between interest rate hedge ratios and inflation hedge ratios has broadly disappeared.

Going back a few years, there was a well-held view that yields would rise, enabling schemes that were under-hedged on interest rates versus (the thought-to-be more fair value) inflation to access interest rate hedging at cheaper levels.

As we know, however, this largely has not been the case, and sponsor companies have been forced to become more focused on managing their interest rate risk in the near term, thereby resulting in the interest rates catch-up shown above.

The evolution of scheme management

The overarching management of DB portfolios has also evolved. Having initially viewed LDI as a solution strictly comprising gilts and derivatives, schemes now view their objectives and the investments used to meet these from a much more holistic perspective.

As such, LDI has grown to include, and dovetail with, cash flow management, corporate bond allocations, and collateral waterfalls, to name but a few.

The potential for improving efficiency of portfolio management through the strategic integration of LDI with other aspects of portfolio management is essential for trustees to grasp.

As schemes mature, preparation for ‘endgame’ is increasingly at the forefront of trustees’ minds — whether that endgame be ongoing self-sufficiency, a traditional insurance solution (such as a buy-in or a buyout), or a more innovative insurance solution, such as an assured payments policy or insured self-sufficiency.

As schemes continue on their derisking journeys and as the low-yield environment persists, we also anticipate that many schemes will seek to manage their LDI portfolios dynamically, both to minimise the risk of rising interest rates (particularly if inflation does not fall back as expected) and, where possible, to seek to add incremental value.

For all investors with long-term goals in mind, the topic of responsible investment is gaining momentum and urgency.

The market is evolving to ensure environmental, social and governance considerations are fully integrated into LDI mandates, through aspects such as counterparty creditworthiness and engagement, and the recent issuance of green gilts is an exciting development. We will be watching closely to see how these are received by investors, and whether they are appropriate for inclusion in client portfolios.

So where will LDI be in the next 20 years? Well, what we can be certain of is that LDI will continue to evolve.

Those who have been early adopters of change have, in general, been best placed to respond to the rapidly changing world, and for all schemes we believe choosing the right partner with which to help navigate the future is of the utmost importance in order to achieve their long-term goals.

Anne-Marie Morris is head of DB solutions strategy at LGIM