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The fallout from the mini-budget left the pensions sector reeling. Fortunately, the BoE stepped in to protect financial stability. Now that LDI vulnerabilities have been exposed during extreme bond volatility, can CDI strategies bridge that gap?
Some solace in improved funding positions, but is it enough?
As the April 2024 deadline for the new DB funding code approaches, schemes are likely to accelerate to a state of low dependency on their sponsoring employers. This means that portfolios must carry low risk cashflow matching assets by the date of significant maturity.
Further, following the gilt crisis, fiscal tightening means schemes have benefitted from rising discount rates, so their funding levels improved across all endgame paths. The Pension Risk Transfer Report shows this is especially true for schemes with mature membership and those preparing for buyout.This has created the perfect conditions for portfolios to reach low dependency sooner than previously thought.
What can asset managers do to keep pace with these developments?
The risks addressed by CDI and LDI are different
Liability-driven investing (LDI) is a value-matching exercise that protects against material risks, such as interest rates and inflation. This is why the mallowstreet LDI 2020 Report produced in partnership with BMO Global Asset Management shows hedging accuracy is a top priority. In contrast, the Cashflow-driven Investing (CDI) Flash 2020 Report produced for abrdn highlights the main risks in CDI are cashflow matching and longevity, as CDI is designed to generate predictable cashflows to pay benefits as they fall due. As a result, CDI hedging is done through the selection of long-dated assets like credit.These two charts are telling of two things:
1. Liquidity ranks much lower in importance than quality of assets and cashflow delivery, for both CDI and LDI. It is worrying to see that schemes find liquidity to be unimportant, given the developments following the mini-budget crisis. As a result, it comes as no surprise that the FCA has called for liquidity buffers among funds.
2. CDI prioritises the volume and timing of cashflows, whereas in LDI, the certainty thereof is not that important. This reflects the different roles each of these investment approaches play.
Liquidity is key to efficient operational execution
The Work and Pensions Committee (WPC) found the complexities of recapitalising fund structures were the ’key cause of LDI market turmoil’ in late 2022. In the unprecedented volatile environment, collateral calls were made which can put an extraordinary amount of stress on operational processes.
In this context, the LDI Report finds efficient execution and fees to be the most valued characteristic in LDI managers, with good reason. Our report also shows that small schemes prefer to access LDI through pooled funds whereas larger schemes favour segregated mandates.Pooled LDI funds were most impacted in 2022, although only making up 15% of the market. They are less equipped to handle collateral calls as their leveraged and unleveraged investments may not be under the same manager. This creates a cashflow negative environment that forces them to sell assets to transfer money back into the fund. A forced sale in a declining market furthers a downward spiral, causing many to enter emergency arrangements to secure capital.
mallowstreet’s research supports this sentiment. At only 11%, low capital requirements was not a valued characteristic of LDI managers based on data from 2020.
Of these 11%, all schemes hired their LDI manager based on their ability to fulfil the low capital requirement. This suggests that few have this characteristic on their radar, but those that do consider it key to selecting LDI managers.
Utilising CDI solutions to counteract the liquidity problem
Our CDI Flash Report also shows that CDI tends to invest in high quality investment bonds, thereby potentially delivering better funding stability than LDI alone, as it can mean less leverage and more use of physical bonds according to Mercer. Long-dated assets like credit appeal to CDI as generating cashflow does not depend on fluctuations in valuations, as revealed by mallowstreet’s CDI 2019 Report with AXA Investment Managers. Any potential losses from credit or duration risks can be recouped if they do not affect coupon payments.
And as CDI coupon payments are unaffected by volatility, collateral calls are less likely to trigger the liquidity need and forced sale of assets we recently witnessed in LDI.
Although quality assets are highly ranked in level of importance for LDI, schemes often invest in LDI solutions separately from other investment grade credit (such as high-quality corporate bonds and other liquid fixed income). This inefficiency could be bridged with CDI’s better, less volatile asset allocation.
Hedge ratios drive asset allocation in LDI
The LDI 2020 Report also finds that for schemes with a high hedge ratio, buy and maintain credit and similar solutions can be quite attractive.
For schemes with a low hedge ratio, other derivative capabilities, such as synthetic credit and equities, have more appeal. A factor for this could be the concern that LDI is inflexible to meet long term objectives at endgame. This is evident in some of the data from the LDI Report 2020. For example, 25% of schemes with the lowest hedge ratios are unsure of the suitability of their current LDI. Additionally, 20% of schemes with a hedge ratio of 61-80% are either unsure or outright state they do not think the approach fits.
More unanswered questions on CDI
Pension funds hold a view that CDI will never be a perfect cashflow matching exercise, due to the natural lag in scheme valuations. As a result, shortfalls can often be recouped with a pre-planned sale of assets and when rebalancing portfolios. Against this backdrop, we agree that the value-add of CDI strategies requires more research. How are schemes differentiating between CDI and LDI given they invest in similar assets and are exposed to the same risks? How can CDI better support DB schemes in meeting significant maturity? With the new developments, will liquidity and asset allocation preferences change?
These are the questions we will seek to answer in our upcoming research on Cashflow Matching Investments, so contact albena.georgieva@mallowstreet.com if you would like to be considered as a research sponsor.
