# Limiting liabilities

## Liability-driven Investment

Liability-driven investment (LDI) is a phrase frequently on the lips of fund managers and pension funds around the world. The situation is no different in Australia, where a number of large superannuation funds - or supers - and defined-benefit corporate pension plans are looking to better match their assets and future liabilities.

Several large supers with defined-benefit components have either established or are exploring LDI mandates. Sydney-based Qantas Superannuation Plan, the A$6.5 billion ($5.38 billion) superannuation fund for Qantas Airways, for example, has asked one of its consultants to prepare a report on the LDI approach. Qantas Super closed its last defined-benefit division to new members in 2003.

"We have a long tail of liabilities, which goes out for the best part of 30 years," says Jeremy Edmonds, former chief executive of the fund, who was replaced in late July by Janet Torney. "The fund is in a healthy state at the moment and we have a reasonable surplus. If there's a time to look at locking in longer-term returns, it's when you're in a healthy position, not when you have a downturn in the market like in 2003 when we felt the effect of severe acute respiratory syndrome, the war in Iraq and the general global economic malaise."

A fund employing an LDI strategy would base its investment decisions on the profile of its liabilities, with the aim of matching the two. With liabilities valued using a discount rate based on bond yields, this often entails investing in long-dated nominal and inflation-linked bonds, and interest rate and inflation swaps.

However, one structural weakness in Australia is its lack of a deep and liquid domestic inflation-linked bond market. Australia suspended its inflation issuance in 2003, with outstanding treasury index-linked bonds at A$6.02 billion as of June 29, 2007, according to the Australian Office of Financial Management. Although the Qantas fund already uses US Treasury inflation-protected securities as a hedge against inflation, the shallow market for domestic inflation-linked bonds is "a cause for concern", says Edmonds. However, his main worry about using an LDI approach is that the plan has a target return of 4% a year over the long term. "To get a 4% real return in Australia, you need a nominal return of about 9% gross - it's very challenging," he explains. Under Australian law, defined-benefit liabilities must be backed by assets in a separate trust, while assets and liabilities have to be reported on company balance sheets, prompting some schemes to consider LDI strategies - although Edmonds says reporting considerations were not the basis for Qantas' decision to look more closely at LDI. "LDI is becoming more of a talking point, and it's something we're not ignoring," he says. "Every year, we conduct a review of what we should be doing to protect the fund's liabilities. Every year, we have talked about LDI, but we have not been talking about it with that specific acronym as such. This is a bit more of a formalised discussion." One fund that has commissioned an overlay mandate with inflation-linked swaps is QSuper, which, in partnership with the Queensland Treasury Corporation, has$40 billion in superannuation and other reserves invested for Queensland state employees and their spouses. QSuper unveiled the launch of a so-called beta mandate last year, designed and operated by its fund manager, Queensland Investment Corporation (QIC). The beta mandate sourced a range of cash and derivatives to match the duration of QSuper's liabilities. It separates alpha from beta in its fixed-income portfolios, and included A$2 billion in derivatives and swap contracts to synthetically create a match to inflation-linked bonds. Susan Buckley, general manager of global fixed interest at QIC, says the lack of a liquid Australian inflation-linked swaps market was a challenge, but not a hindrance. "It is part of a global inflation mandate, including the use of synthetic instruments, so we're not hamstrung by the potential illiquidity and lack of supply in the domestic market. We do undertake research globally and tap into the swaps markets in Europe, Japan and the US," she says. Optimism In fact, Buckley says she is optimistic there will be increased issuance of inflation-linked bonds from the Australian corporate sector over the next few years. "That is sometimes lumpy but, to continue the infrastructure development that is needed in Australia, there will be a pipeline of those kinds of investments over the next year or two." But not everyone thinks LDI is a panacea. Scott Donald, Sydney-based director of capital markets research at Tacoma, Washington-based multi-manager investment firm Russell Investment Group, warns that LDI is an issue that only a small number of very large funds should think about very carefully. "Which is not to pour cold water on the idea in Australia, because we're talking about very large funds and a potentially very large dollar amount. But I'm not sure the average superannuation fund has need of this," he says. That's largely due to the dominance of defined-contribution funds in Australia, which means the risk of shortfall lies with the employee rather than the employer. What's more, a recent survey of Australian-listed companies by consulting firm Watson Wyatt shows the liabilities of the country's defined-benefit schemes are more or less covered by assets. The survey reported liabilities at A$40 billion (this did not include public sector defined-benefit liabilities or those of Australian subsidiaries of overseas companies), but once the value of assets had been taken into account, defined-benefit schemes had a net liability of less than A$1 billion. "In Australia, because there are so few defined-benefit funds and most have an operating surplus, selling the LDI instruments popular in Europe has less relevance to the Australian market," says Nick Hamilton, head of offshore and institutional business at k2 Asset Management in Melbourne. "We're not seeing the push from this stage of the market, at the end of a strong equity market. We are seeing a move to exotic instruments, but not inflation-linked instruments, and we're not seeing the wholesale move out of equities into bonds." The Australian superannuation fund industry has A$1.1 trillion in assets under management as of March 2007, according to the Australian Prudential Regulatory Agency (Apra). At June 2006, A$511.9 billion in assets were held by defined-contribution funds. Pure defined-benefit funds held A$56.4 billion of assets in total, and hybrid funds - those with a combination of defined-benefit and defined-contribution members - held A$299.9 billion, according to Apra's 2006 annual report into the superannuation industry. An additional A$211.5 billion was held in self-managed superannuation funds.

Where LDI may apply to defined-benefit plans, it is most easily implemented in the form of pooled fund vehicles offering access to inflation-linked bonds in different duration buckets to match the liability risk, says Tim Unger, a senior investment consultant in the Sydney office of Watson Wyatt.

"I don't think a lot of funds are looking to match their liabilities very, very closely," he explains. "If you've still got 40%, 50% or 60% of the fund's assets in risky assets, there is no point trying to match liabilities exactly with the remaining assets. But having pools of inflation-linked bonds would make it relatively easy to get exposure to assets that provide a reasonably good match to the liabilities."

QIC's approach to the beta mandate is to view risk holistically rather than try to match solely actuarial risk, inflation risk or interest rate risk, explains Adriaan Ryder, head of beta management at QIC, who has direct oversight over QSuper's beta mandate. "The way we think about it, it's really about risk management. It's not saying we're going to hedge one outcome. One way to approach it is to say, "let me understand my interest rate risk and inflation risk", which may equate to wage inflation risk for defined-benefit plans. It's understanding that 50-70% of the liabilities in a defined-benefit plan are very sensitive to interest rates and inflation rates," he says.

But the practicalities of designing QSuper's beta mandate were challenged by the shortage of Australian inflation-linked bonds and swaps, along with the need to find counterparties for the deals. To begin with, the lack of inflation-linked bonds compared with overseas markets meant difficulties finding an approximate curve to match liabilities, Ryder says.

"When I came here from the UK, the first thing I realised was that I couldn't buy an inflation-linked bond. Most things were done in swap format in the UK. Other markets were very liquid indeed, but not here. The initial process was, 'how do you price something when you don't have a curve?' And even the nominal curve doesn't extend out. As a back-up, I would proxy Australian inflation until such time as I could source Australian inflation. That's the model I used," he explains.

On the legal and compliance side, QIC has signed International Swaps and Derivatives Association (Isda) agreements with 16 possible counterparties, negotiating with eight or nine of those counterparties as an ongoing process. It has transacted with six of them for the beta mandate, says QIC's Buckley. In addition to using Isda documentation, QIC sought credit support annexes with its counterparties before transacting with them, Ryder adds.

As a general rule, counterparty risk is poorly understood by superannuation fund investors, says Donald of Russell Investment Group. "The amount of coverage required to implement these strategies, through either direct strategies or through derivatives overlays, is quite enormous. Investors going into this particular line of investing have to look very carefully at the credit risk inherent in the positions they're taking up. Most people are going to have to use some form of structure or derivative to build this. The danger is you end up with an open-ended risk," he says.

There is also the issue that the pricing of deals is contingent upon a counterparty's credit rating. "It's not just the chance that one of your counterparties does a Barings and disappears," adds Donald. "While it's unlikely that an AA+ rated bank will disappear in 20 years, it's not impossible for its credit rating to change. That means the pricing for your deal can change, and that's not normally factored into the analysis of LDIs. If you want to do this type of strategy in Australia, someone will come to the party, but you must take into account the credit risk."

As superannuation funds consider the risks, rewards and applicability of LDI to their model, professionals stress that the debate itself is valuable. The discussion of LDI has led to increased interest being paid to liabilities, which fund managers and superannuation funds alike acknowledge is an important consideration. It may not lead to increased uptake of LDI strategies, but a closer scrutiny of liabilities is never a bad thing.