What’s happening with liability driven investment strategies?

There are many schools of thought when it comes to investing. Sustainable investing, growth-investing and value-investing all have different levels of risk to different types of investors.

While some philosophies are considered more ‘out-there’, others are applied often. Liability-driven investment strategies are one of the more common approaches to pension-funds, having grown in popularity since the early 2000s. 

Now though, we may have hit a bump in the road.

What are liability driven investments (LDIs)?

Liability driven investments (LDIs) are ways for investors to match their income generated from investments to expected expenses. 

Most often, LDIs are used in defined-benefit pension plans, since individuals can set a goal for their annual withdrawal amount. This makes it fairly simple to determine how much extra money they require to be generated from investments, and can therefore make decisions to invest in revenue-generating assets at the right level of risk. 

The overall goal of liability driven investment strategies into a pension fund is to ensure that there is no shortfall in fixed income for retirees. Moreover, this type of investment strategy is important since it provides collateral to pension funds, encouraging further investment. In the wider economy, pension funds provide access to cash flow for operating companies, allowing them to develop and continue to strengthen the economy.

October 2022 LDIs events

Let’s say that a pensioner has determined that they’ll require £20,000 in annual withdrawals from their pension schemes. So, in line with liability driven investing, the investor purchases an amount of stocks and bonds that is expected to pay out £20,000 annually. 

But in late September and early October 2022, the bond market and LDIs faced significant challenges. With a hike in interest rates, pension funds were forced to find extra collateral. Instead of £20,000, the pensioner would now require their assets to generate £22,000 to have the same quality of life. Fund managers needed to grow the pension fund to match this new liability, since the expenses of all pensioners would rise in line with inflation. 

Without many choices, pension funds were forced to sell off gilts, which are a type of government-issued asset bonds, at a discounted rate. At the same time (due to political events) gilt yields increased quite significantly, which led to a further fall in their value. 

The Bank of England stepped in, offering to buy billions of gilts in order to provide collateral for these pension funds. But in reality, they have bought far less than promised. This leaves us with a gap in the revenue generated by pension funds, and the total expenses of pensioners. 

Benefits and challenges of LDIs

In theory, LDIs have several advantages, which is why they became such a popular strategy for pension fund investments. But, as we can now see, there are some problems with the way that things are working currently.

Benefits

Since they have reporting and monitoring frameworks, they bring more information governance to investors. Moreover, LDIs are supposedly a lower-risk way to invest, as you are theoretically guaranteed to make ends meet by matching income-generation to your lifestyle expenses.  

Moreover, LDIs follow the general principle of de-risking. As investors become older and the reliance on investment income grows, we often see risk-taking decrease. LDIs act in accordance with this risk model. 

Challenges

The most prominent challenge in LDIs is that, during times of fast-market movement, LDIs struggle to match the income generated by assets to the rising cost of expenses. Some pensioners are withdrawing from their pension plan right now, and need an instant response to inflation. LDI strategy works better in a slow-moving market, which gives fund managers the time to find assets that match up. 

Moreover, when interest rates rise, new bonds pay investors higher interest rates than old ones, which decreases the value of historic bonds. Unfortunately, this means that every government bond with a long maturity period acquired by pension funds is actually negatively affecting the pension fund’s value.

The consistent gap and catch-up nature of LDIs is creating volatility in the wider economic markets. While pension funds are traditionally relied upon to front debt financing for company development, LDIs are now causing instability. The knock-on effect of this is fewer available cash investment opportunities for businesses, leading to reduced economic growth.

Regulatory requirements for LDIs

Currently, the Pensions Regulator and Pension Protection Fund regulate pension scheme strategies in the UK, which many LDIs fall into. Companies that manage pension funds are subject to many of the general prudential requirements of financial institutions. 

However, we’re expecting to see changes to the way that LDIs operate as a direct result of recent events. 

To ensure that your company is on top of any changes that are coming, ensure you’ve got access to horizon-scanning technology. You’ll know about regulatory updates as soon as they are announced, and can begin to implement compliance measures instantaneously.