Marcus Mollan is head of strategy in the Pension Solutions Group at Legal & General Investment Management (LGIM), one of the leading managers in the field of liability-driven investment, with more than £90 billion in derivatives under management. His role is to design and implement risk management solutions, involving both derivatives and physical assets, for pension schemes and other institutional investors.
Legal & General Investment Management was one of the first organizations to offer LDI to final salary pension schemes as a way for both trustees and the sponsoring employer to manage risk. How useful is LDI today?
As the name suggests, liability-driven investment (LDI) for pension funds is a way of matching the timeframes of the benefits that a fund expects to pay out, with the maturity date of its assets. The idea is to take risk out of the scheme by locking in a guaranteed return that will mature when the fund needs it. However, there are risks in LDI itself that scheme trustees and sponsors need to consider. In particular, inflation is a key topic for the trustees and sponsoring employers of defined-benefit pension schemes in the United Kingdom. This is because around 70%–80% of the liabilities of most schemes are inflation-linked. Since 1997, when the UK government introduced mandatory indexation for final salary pensions, trustees and sponsoring employers have had to take into account the fact that most scheme benefits have to increase in line with inflation, although this inflation protection is typically capped at a maximum of 5% per annum.
As a result of this inflation cap, UK pension scheme trustees and sponsoring employers are particularly concerned about the risk of a scenario where long-term inflation remains consistently above the Bank of England’s 2% target, yet below the cap of 5%. With recent inflation levels being recorded at around these levels, there has been discussion about how risk reduction can be achieved using LDI techniques.
At first glance it may appear that a deflationary scenario would benefit pension schemes; however, unfortunately this also tends to be an adverse scenario. This is because most schemes have a “floor” in place, which means that pension benefits do not decrease year-on-year, irrespective of how deflationary the real economy becomes. If we have a negative inflation rate, pensions are still paid out at a flat rate, while inflation-linked assets may suffer. So trustees have to manage the risks in both directions—inflationary and deflationary.