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Liability driven investment is as much a buzzword in
pensions as ‘absolute return’ is in fund management. LDI is about matching
income with calls on future cash flows in a pensions deficit-ridden corporate

But wasn’t it ever thus? Well, maybe not, as long as pension fund trustees
were able to get by with working out their pension fund obligations by ‘present
valuing’ them using gilt-related discount rates when gilts were providing better
returns. But that’s all changed.

It’s much more pressured now. FRS17 requires that pension fund assets are
marked to market more rigorously, that a relatively lower discount rate is used
to calculate liabilities and that this more detailed information on pension fund
valuations is open to public scrutiny. The demographics have moved against
pension provision as life expectancy continues to rise, while interest rates and
fixed income yields are low and the return from equities over, say, the past six
years as a whole, has been sub-optimal. PricewaterhouseCoopers has calculated
that pension fund deficits among FTSE-350 companies now amount to £70bn.

To up the ante even further, the new Pensions Regulator has just released its
medium term strategy, which was critical of the competence of pension fund
trustees. “Our experience is that the standard of governance of many schemes,
particularly smaller ones, is poor,” it says. “Our in-house research shows clear
evidence of low standards of trustee knowledge and understanding, particularly
in schemes with fewer than 1,000 members… Trustee conflicts of interest are also
a concern, especially in defined benefit schemes with funding difficulties.”

In addition, perceived poor governance and fund management performance now
cast a long shadow of reputational risk over corporates. Ratings agency Standard
& Poor’s has placed corporates on credit watch where it felt that they were
at risk of defaulting on their pension fund obligations.


So the issue of pension fund valuation is now thrown into sharp relief. Get
it wrong and employ the wrong investment strategies and the result is to fall
foul of all your stakeholders and the regulators.

Consultants Watson Wyatt codify valuation into three categories:

  • Discontinuance valuation – based on totalling what all scheme
    members’ benefits would amount to if the scheme, as a whole, was terminated at
    the date of valuation. This establishes the full scale of a scheme including all
    of the variables having to do with the number and age of scheme members, their
    life expectancies and probable future benefits.
  • Accounting valuation – apart from meeting accounting requirements,
    this method summarises members’ accrued benefits and future likely benefits as
    at year-end. It also takes a view on how future benefits will increase in light
    of likely future rises in salaries.
  • Funding valuation – calculates future scheme contributions and how
    funds should be invested.

Liability driven investments

The result of Watson Wyatt’s approach, as with those of other consultants, is
that it establishes the probable scope and profile of the scheme. And this, in
turn, forms the basis of LDI: how liabilities define investment strategy. The
reason why managers have coined the term is that, whereas previously it was
enough to match liabilities’ cash flows with those from bonds, leavened with
equity dividends and capital growth, neither ingredient now produces the best
outcome in view of the burgeoning obligations. “The liability benchmark is the
portfolio of assets that best matches the [pension fund’s liabilities’] cash
flows,” says Andy Green, European director of consulting at Mercer Investment
Consulting. “This will generally be defined as a combination of fixed interest
and index linked assets and includes both government bonds and swaps.” However,
this points directly to the issue of risk.

“You’ve got a critical decision to make once you know what your profile looks
like, once you’ve decided what your investment aims are and how much risk you
want to take,” says Green. “That is the implementation decision. Do you, the
trustees, retain the control of the investment policy? Do you hire a specialist
manager for each part of the portfolio in order to gain from their specialist
skills? Or do you have one overall manager, so that you can switch between asset
classes as and when necessary?” Another decision to be taken is whether a
manager should be active or whether it will be sufficient and cheaper to invest
via index linked funds. Indeed, should one manager be able to offer a variety of
approaches and strategies? According to Mercer, “We now have an environment
within which consultants, managers and investment banks are each competing to
provide full solutions to trustees. Hence, more than ever, it continues to be
important to separate the genuine value-enhancing strategies from those
following fashion as a means to gather assets or to execute deals.”

Managing the managers

No wonder the Pension Regulator feels that many trustees need a more thorough
grounding in investment management, with the best and4 brightest from the City
of London and the fund managers of Edinburgh, ranged against them. Much has been
made of the conflict of interest faced by company executives and particularly
finance directors who also act as pension scheme trustees. But John Belgrove, a
senior investment consultant at Hewitt Associates, says: “Sadly, there are fewer
FDs that are able to wear the trustee hat. I accept the conflicts issue, but
largely they bring a lot of strengths to the trustee board in terms of financial
knowledge.” Nowhere, perhaps, is this more the case than in the context of
seeking superior returns and separating the wheat from the chaff among
investment managers.

For many trustees, bonds, equities and cash have failed to bridge the
ever-yawning gap between a safe return on their fund and its deficit. And yet
certain asset classes have performed very well – or even spectacularly (see
box). These include private equity, commercial property, hedge funds,
commodities, emerging market debt and equities, private finance
initiative-related bonds, currency management and pure stock picking in
equities. Belgrove advises that trustees need to take the view that “these
options are all part of the mix and it’s all back to ‘What am I trying to
achieve? What am I worried about going wrong and how quickly do I need to
achieve the results I am aiming for?’”

The trustees are faced with the task of finding managers who can get the best
out of these various high return markets. Belgrove and others advocate carefully
managing the managers, setting them well-defined targets. Such targets are
likely to be absolute return, those unconstrained by standard benchmarks such as
a return over cash or in relation to gilts, FTSE or other standard indices.
Another important feature of retaining managers for the specific purpose of
accessing superior returns is to limit the amount of money they run for the

Worryingly, there seems to be a trend among some pension funds to buy
exposure to markets late in the day by which time the early adopters have
already extracted the high returns and when the risks of market downturn are
increasingly acute. The current flood of funds into private equity, funds of
hedge funds and commodity-based exchange traded funds may be cases in point.

So while the ceaseless quest for return continues, the job of pension fund
trustees gets no easier. Indeed, it becomes increasingly pressurised in direct
proportion to the increasing scale of fund deficits and the degree of public
scrutiny brought to bear on pension fund performance. It is not surprising that
there is a relative shortage of people prepared to act as pension fund trustees
although it is such a vital role in the context of the importance of
occupational pensions in the lives of increasing numbers of retired former