"It is already beginning to happen in the U.S. among larger companies," said Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management PLC, Aberdeen, Scotland. "What's guiding the market (in LDI) is risk reduction, not a focus on return. This is an important distinction."
At its core, LDI is the practice of making investment decisions based on a framework that reflects projected liabilities, rather than an index or peer-group benchmark. There are several ways of accomplishing that: structuring a fixed-income portfolio that matches expected cash flows; using swaps and hedges to synthetically reduce volatility between assets and liabilities, for example, by matching durations beyond the end of the actual bond duration; and focusing on a multiasset strategy to gain diversity for long-term growth while setting aside a tranche of assets to match liabilities.
Because of the array of products under the LDI umbrella, it is difficult to measure just how much pension funds are investing in liability-driven strategies. But there's no doubt the market is booming.
"There's such a significant, immediate demand that it's essentially a seller's, not a buyer's, market" in Europe said Kevin Carter, European head of investment consulting at Watson Wyatt Worldwide, Reigate, England.
Inevitably, this culminates in a scramble to get on the bandwagon because "that's where (managers) see the opportunity at the moment," added Ralph Frank, senior consultant at London-based Mercer Human Resources Consulting Ltd.
Led by the United Kingdom — where lower-than-expected equity returns and new accounting standards have left substantial deficits in many pension plans — liability-driven investing is a way of reducing volatility between assets and liabilities. The framework also fits snugly into the more general drift of continental Europe toward a mark-to-market system.
While the concept is not new, the recent emergence of liability-driven investing as a preferred strategy has been driven not only by need, but also by design, Mr. Frank said. The increasing focus on pension liabilities on a company's balance sheets has upped the ante so that investment banks and corporate financial executives are more involved in investment decisions. Trustees and corporate executives also are now more comfortable with such sophisticated instruments as swaps and hedges to decrease volatility. In turn, this not only benefits the bankers who are counterparties to such transactions, but also asset managers, many of which are subsidiaries of the banks themselves.
"That's where the hype comes from," Mr. Frank said. "Investment banks are marketing more aggressively to trustees and corporate sponsors, raising awareness of the financial risks and instruments that may be used in managing those risks."
State Street Global Advisors Ltd., London, worked much more closely with corporate sponsors in its effort to wrest away the £873 million W.H. Smith PLC's pension fund from BGI and others in one of the most publicized coups this year.
"The move toward LDI is driven, at least in part, by corporate sponsors' familiarity of risk management and their strong desire to control risk," said Richard Lacaille, SSgA's chief investment officer of Europe. "The growth in our business has mirrored that development. We've found ourselves speaking to corporate sponsors to a greater degree than we would otherwise."
Alan Stewart, group finance director at London-based W.H. Smith, said the pension plan's decision to restructure was "absolutely driven" by a need to reduce volatility that outweighs the need for maximizing returns.
"With LDI, there's a much narrower range of possible outcome of return. Investors tend to forget that there's a significant upside to equities, but there's equally a significant downside that ultimately ends up on your balance sheets."
W.H. Smith's LDI strategy essentially deals with assets-liabilities management by extending duration using inflation swaps targeting the London interbank offered rate for 94% of its fund. The rest is placed in long-dated equity call options.
Traditional balanced portfolio managers also are trying to gain a foothold in the LDI market by introducing a client-specific, liability-led benchmark into a multiasset strategy.
Because balanced mandates have been on the wane in the U.K. and Europe for the past few years, the new multiasset platform is viewed as a way of capturing some of the lost market share. London-based Schroder Investment Management Ltd., for example, has gained about €300 million so far this year in this type of strategy, said Curt Custard, CIO of multiasset solutions at Schroder.
