www.the-actuary.org.uk
However, 50% cash is still higher than
the average scheme's existing allocation to
bonds, so represents a sacrificing of return
potential. More recently, managers have
launched funds that squeeze the level of
cash required down from 50%. The more
they succeed, the higher the return potential,
so LDI becomes applicable to a wider range
of circumstances and requirements. At some
point, sacrificing the potential to capture a
risk premium stops being a valid reason not to
adopt an LDI strategy.
Moving goalposts
In the early days, moving to an LDI solution
meant an implied value of liabilities, based
on swap rates, significantly higher than most
schemes reported in their actuarial valuations.
Many viewed this as suggesting that LDI was
an expensive option that meant locking in to
low long-term interest rates.
However, these are market rates
-- they contain information about
expectations for cash returns into the
future. Yes, they may be distorted by
supply and demand imbalances. Yes, there
is room for strategies that don't hedge
all of the liabilities or tactical positions
reflecting shorter term beliefs but these
should be adopted consciously with an
understanding of the risks that are being
left on the table as a result.
An acceptance of this has spread across
the industry, reinforced by comparable
numbers from other valuations that use
(near) risk-free rates. Accounting, PPF
and buyout valuations are increasingly
important and the high numbers attached
to them mean that a swap-based valuation is
no longer the outlier. In addition, if the LDI
fund is partially funded, there remains the
potential for excess return.
Education, education, education
So, we now have a solution available to
both small and large schemes, providing
a pragmatic but still effective bucketed
hedge of their liabilities. It does not overly
restrict the return potential, but does reduce
the liability risks they face. This sounds
applicable to more than just the minority.
There is no doubt that this is a complex
area, which is a little more challenging than
our collective comfort zones of equities
and bonds. However, that is not a reason to
dismiss the potential benefits; grasping the
difficult concepts and communicating them
to clients is supposed to be one of the core
skills of our profession, after all.
Increasing awareness, understanding,
acceptance and belief in LDI is a slow but
ongoing process. This has only occurred
through patient explanation, education
and training, initially within the consulting
community and then with clients, and this
needs to continue.
The future
So, finally, a little crystal ball-gazing, from
which I can promise that some, none, or all
the predictions may come true, but offer some
insight for each of the key participants in LDI:
n Fund managers need to continue with the
development of more efficient structures.
This may not mean just reducing cash
requirements, but also finessing the way
that exposures are gained. There could be
better specification of cash flows -- limited
price indexation and so on, addressing
mortality risk or more sophisticated
structured investment-type solutions, using
a wider range of derivatives.
n Investment consultants should grasp
the opportunity, and rethink how they
set investment strategy in a world where
addressing liability risks does not mean
placing restrictions on how assets are
invested and returns are sought. Theirs is
the real requirement to understand
the issues that arise with LDI
strategies, and be the independent
arbiter of what is appropriate for
their client base.
n Scheme actuaries will need
to consider using swap-based
valuations, reflecting the full-term
structure of interest rates, and
understand the interaction between
the way assumptions are derived
and the LDI hedging strategies that are
implemented.
n Trustees and sponsors have the
somewhat unenviable task of getting
to grips with all of this, ensuring they
make the most of the opportunities now
available to develop a strategy that is
appropriate for their needs without taking
their eye off the widget machine.
n I will watch with interest as the
market continues to develop flexible
investment approaches, combining liability
management and return-seeking assets.
Figure 3: Increasing LDI returns
�Accounting, PPF and
buyout valuations are
increasingly important and
the high numbers attached
to them means that a
swap-based valuation is
no longer the outlier �
Liability matching
LDI swaps
Return generation and collateralisation
First generation LDI Second generation LDI Latest generation LDI
5% 6.5% 7.4%
Expected return1
1
Approximate based on 5% return on collateral assets 8% on growth assets
Liabilities
LDIswapoverlay
Cash
Return-
seeking
assets
Cash
Cash
Reduced
cash
holding for
collateral
Increased
exposure
to return-
seeking
assets
Investment LDI
The rise and rise of LDI (continued)
Return-
seeking
assets
30 October 2008

Page 1Page 2Page 3Page 4Page 5Page 6Page 7Page 8Page 9Page 10Page 11Page 12Page 13Page 14Page 15Page 16Page 17Page 18Page 19Page 20Page 21Page 22Page 23Page 24Page 25Page 26Page 27Page 28Page 29Page 30Page 31Page 32Page 33Page 34Page 35Page 36Page 37Page 38Page 39Page 40Page 41Page 42Page 43Page 44Page 45Page 46Page 47Page 48Page 49Page 50Page 51Page 52Page 53Page 54Page 55Page 56Page 57Page 58Page 59Page 60Page 61Page 62Page 63Page 64Page 65Page 66Page 67Page 68Page 69Page 70Page 71Page 72Page 73Page 74Page 75Page 76 Produced by PageSuite