The problem with the traditional approach to meeting this goal, however, is that a typical balanced portfolio cannot guarantee either a fund's stability or the expectations of its pensioners, he said. Rapidly changing economic circumstances might render increases linked to a fixed percentage, CPI (inflation) or market performance dangerously exposed. Returns would be volatile, pushing the fund into hard-to-manage surpluses and deficits.
Liability-driven investment's (LDI) chief virtue is that it ensures that a fund's assets and liabilities move in line, providing a stable funding level and greater certainty that pension increases will be met.
In today's unsettled market environment, LDI is able to compensate for inflation and interest-rate risk without compromising the returns a fund may promise its pensioners.
Trustees need to look at their scheme's needs and circumstances in terms of its surplus or deficit, and gauge their appetite for risk accordingly. Only then can they build a solution that allows returns to be enhanced at the same time as mitigating risk.
A traditional method may be 100% invested in a diversified portfolio of different asset classes. This may appear to offset market risk, but expectations of real, inflation-beating returns may not be met - mainly because the strategy serves up a mismatch of assets and liabilities. And subjective decisions based on volatile returns can lead to overly conservative or overly optimistic pension increases. This is where LDI offers a fair, realistic and workable solution.
The essence of LDI is that it manages assets with a constant eye on liabilities. Through 'dynamic hedging', a fund's cash flow can be properly managed to cope with fluctuating inflation or interest rates. The outcome would be better risk management, leading to a more stable funding level and hence allowing better certainty of pension increases.
An LDI strategy would take into account a fund's policy regarding increases in benefits as well as its funding-level affordability and risk appetite. With this data, a stress-tested model would be created to ensure the optimum outputs, which for any fund would be increases in benefits and a stable funding level.
Effective partnerships are behind LDI's tailor-made solutions. Asset managers, trustees and advisers must work with the fund's consultants, actuaries and administrators to devise the best way to match specific needs.
The most conservative LDI strategy would mitigate interest rate risk through investment in the money market, bonds and swaps. This would provide a stable funding level, albeit with limited upside. To sweeten returns, a fund could overlay its core investments with low-risk enhancements to its LDI strategy. This might entail investment in other asset classes, including credit derivatives, in the search for market-beating 'alpha'. Such a process would be absolutely flexible and customised to each fund's particular requirements.
While the modern concept of LDI may seem unfamiliar to retirement fund trustees more used to traditional asset management, trustees should remember that a properly executed LDI strategy will greatly enable a fund to more confidently meet its long-term goals and the needs of its pensioners.
