• To LDI or not to LDI? A question

    Posted on 13 February, 2013 by Robert Pullan in Investments, Scheme Funding.

    If one accepts a market based methodology to value pension scheme liabilities then success in funding terms over time is determined by whether the investment return on the scheme assets exceeds the market based change in value of the liabilities. This is of course subject to some caveats, the largest one of relevance to people thinking in £ terms rather than %s, being the size of the starting deficit where the change in the value of liabilities itself becomes of some consequence. The change in value of liabilities is usually taken to be the change in the value of the scheme’s Liability Benchmark Portfolio ie the portfolio of assets that, other things being equal, maintains its current funding level as economic conditions change. Or in simpler terms, we can usually take this to be a portfolio of gilts, gilt strips and index-linked gilts.

    A LDI strategy is transformational. Transformational in the sense that it changes the success criteria from one of scheme asset returns beating the change in value of gilts to one of beating cash or more correctly beating the short side of the swap. Assuming of course that the swap is properly constructed.

    LDI strategies first became popular in 2003 or thereabouts. About the same time that cash became trash and gold was still $300 to $400 per ounce. Which is the same thing as saying that over the whole lifetime of LDI based strategies all assets have been appreciating against cash, in particular precious metals, government bonds and high yield/junk bonds. How not to succeed? I am not denying there was a large blip in 2008 and 2009 but, to date LDI strategies have not been seriously tested with a prolonged period of poor asset price performance.

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