There’s no two ways about it – Q1 2020 was one of the most difficult quarters in history as the COVID-19 pandemic swept across the globe. 

UK DB pension schemes also suffered in the pandemic’s wake, as almost all growth asset classes experienced significant drawdowns, harming funding positions. 

However, schemes that had invested in “dynamic” Liability Driven Investment (LDI)  which use both gilts and swaps did have some solace, as these funds provided excellent absolute and relative returns, showing its value as a diversified source of return.

Dynamic and passive LDI – what's the difference? 

There are two main instruments used within LDI portfolios: gilts (or UK government-based bonds).  In practice these are usually combined with some form of leverage (or borrowing) to achieve capital efficiency; and swaps.  These are capital-efficient financial instruments which change in value if interest rate or inflation expectations (used to value pension scheme liabilities) change, thereby tracking pension scheme liabilities. 

The most basic approach to LDI (generally called passive) is to use just one of these instruments and construct a portfolio which mimics characteristics of the scheme’s projected benefit payments.   A scheme with payments projected further into the future might wish to buy longer-dated gilts in its LDI portfolio than a scheme with the majority of its payments expected in the near future.  The instrument chosen should reflect the characteristics of the liability measure that is being tracked..  For example, most pension schemes calculate their funding liabilities with reference to gilt yields, so will use a gilt-based LDI portfolio.  Insurers are more likely to use swaps within their valuation of pension scheme liabilities. 

Generally, we prefer a more sophisticated approach – dynamic LDI.  This approach uses a combination of both gilts and swaps and biases the portfolio towards the cheaper of the two instruments and also updates weightings between the two instruments in real time to capture changes in the relative prices.   

The rationale for the dynamic approach is simple – both gilts and swaps provide natural, capital-efficient hedges to pension scheme liabilities with assets that are as close to risk-free as possible.  Therefore, it’s reasonable to weight more towards the cheaper asset.  The process of systematically rebalancing (a simple buy low, sell high strategy) crystallises investment gains.  This works because the relative pricing of nearly equivalent gilts and swaps is volatile, despite their similarities.  

How do I choose the right LDI approach for me? 

LDI is designed to track a certain liability measure and so the effectiveness of your LDI strategy will be dependent on tracking the most appropriate liability measure for your scheme.  For example, schemes focussed on funding valuations may wish to use a passive gilts-based approach to LDI as this approach most accurately tracks funding liabilities.  However other approaches, such as dynamic LDI, offer potentially attractively (diversified) returns for a reasonable level of risk. 

For a lot of schemes, the end-game is an insurer transaction and insurer pricing is driven by gilt-pricing, swap-pricing, credit spreads, commercial pressures and various other factors.  Therefore, investing in a mixture of gilts and swaps (such as dynamic LDI) may actually be more effective at matching insurer pricing.

LDI has protected schemes across the board 

Having LDI (regardless of whether it is dynamic / passive) in place has been really beneficial to schemes over the last few years.  This is because government bond yields have fallen to record lows.  Therefore, schemes with LDI have been protected against rising liability measures, which may have increased by as much as 40% over the last seven years. 

Dynamic LDI has seen even better results than LDI 

Over long timeframes, the dynamic LDI approach has added excess investment returns relative to both gilt and swap measures of liabilities.  For example, over a seven-year timeframe, outperformance has been around 7% above gilts and 40% above swaps.  I think it is impressive to have outperformed both gilts and swaps, using just gilts and swaps.  Over shorter timeframes, the outperformance relative to gilt-based LDI is small and dynamic LDI has consistently performed a lot closer to the higher performing of the two instruments. 

Using dynamic LDI is expected to increase returns over the medium to long term, which can allow for a more measured approach to risk-taking in other parts of the portfolio.  Given the current challenges in investment markets, it is crucial that schemes use all of their assets in the most efficient way possible.  A dynamic LDI fund could be a great way to achieve this and accessing it is not as hard as you think.  There are a range of easily accessible pooled funds available to schemes as well as more bespoke options too.  Speak to me or our investment team to find out more.