LDI vindicated by recent market conditions, say trustees

The recent spate of equity market volatility and the concurrent rise in the three month libor rate has impacted the liability-driven investment approaches put in place by pension schemes as part of a de-risking strategy, with the chairman of the trustees of one such scheme warning it was a "sobering lesson" for those schemes with a sizable equity component.

According to Chris Holden, chairman of the trustees of the £3 billion Marconi pension scheme, stock market and credit market volatility has changed the picture of pension scheme funding overnight. Telent's status as a mature scheme with a large portion of its funding in bonds has enabled it to ride out the recent storm - for now.

According to Holden, "Fortunately, Telent appears to have escaped with no immediate damage to its funding position. I would say that we are a fraction of a percentage point worse off than we were eight weeks ago. So in that sense, our risk model has done what it was supposed to do, although testing of the model is an ongoing process."

But Holden warns that there may be further shocks around the corner which could negatively impact on healthy funding status. Holden cited leveraged loans to private equity firms as an example, with a lack of transparency making providing accurate valuations a complex problem. "It is easy to value a corporate bond or equity but right now there is no market price for leveraged loans, so pension funds have to depend on their fund managers for valuations - but could some of these be hiding problems from their pension fund investors."

But according to Holden, younger schemes with a greater allocation to equities are exposed to an asymmetric risk, "Because equity markets tend to drop very rapidly and only recover slowly. So while healthy equity markets over the last two years have got rid of their IAS19 deficits, that has now been wiped out at the stroke of a pen."

The 88 basis point spike in three month London inter-bank borrowing rates (Libor) up to 6.88% - 113 points above base rates - since the sub prime contagion started impacting the market at the start of July, has already led one major UK pension scheme to delay implementing its proposed LDI strategy until the new year. According to the pension manager on the multi-billion scheme, rising spreads meant it was uneconomic to complete all tranches of the proposed LDI structure in the original time frame.

Some observers have suggested that in addition to putting a halt on the implementation of LDI programmes, this continued upward trajectory in spreads would undermine the de-risking rationale of LDI, with the returns on assets unable to support the pension scheme's payments on the Libor portion of interest rate swaps.

Marconi is one pension fund that has extensively used swaps to hedge its liabilities. But Holden is comfortable with the behaviour of his derivative portfolio, which is backed by high grade bonds. "It's a quid pro quo - long dated interest rates have gone up, so while our swaps have lost money, we have gained on the market valuation of our liabilities."

According to Jeremy Stone, chairman of the trustees of the £800 million WH Smith pension scheme, which moved into an LDI approach in 2005, the current turmoil does highlight the importance of choosing the right assets to back Libor payments.

He says that some banks proposed that the WH Smith pension scheme back its swaps by investing directly in collateralised debt obligations (CDOs) but he is glad to have chosen instead a guaranteed Libor product structured by Goldman Sachs.

With this structure, it is Goldman Sachs that takes the risk that structured credit assets might decline in value. "Of course, this still leaves the risk that the counterparty does not have the cash available - but this is a remote risk." Stone conceded that it was, "A brave man who says that this won't ever happen," but declared himself satisfied in the case of WH Smith using Goldman Sachs as counterparty.

WH Smith's LDI arrangement was a bespoke programme closely tailored to the needs of the £850 million fund and Stone conceded that a smaller fund - a £100 million or less - would be exposed to more risk. "For a scheme of this size, an LDI fund would be the preferred option. What these say they do on the tin is to minimise - but not eradicate - your curve risk, and those type of approaches could be more exposed to recent market conditions."