Asian pension funds shun LDI
Liability-driven investment may be the hot topic in Europe and America, but it is DOA in Asia û at least for now.
The following article first appeared in AsianInvestor magazine, April 2007.
DOA: dead on arrival. Whatever its merits, liability-driven investment is not gaining a toehold among pension funds in Asia.
This is not what fund managers and investment banks want to hear. They have built a very nice business in Europe and the United States around a sensible idea: that pension fundsÆ traditional assumptions arenÆt accurate, and therefore they are exposed to the risk that they wonÆt be able to ultimately meet their obligations. Providers and consultants are keen to introduce these ideas to clients in the Asia-Pacific region û and sell advice or products on the back of them.
So far they have been rebuffed. First: why? Second: will this change?
The answer to the second question is yes. To understand how, though, requires figuring out the answer to the first question.
There is no set definition for liability-driven investment. It can be interpreted to simply mean a more sophisticated management of beta; it can just mean a derivatives product; or it is a strategy to deal with future uncertainty about liabilities.
Some providers note that LDI is simply a dressed-up version of asset-liability matching that uses financial innovations to realise the abstractions of ALM in a practical way.
A combination of regulation, accounting-rule changes and market events forced pension plans in Europe and more recently in America to review their assumptions.
The Nordic countries were the first in 2000 and 2001 to tighten accounting rules for pension funds. The Netherlands and the United Kingdom followed in 2004, and last year the trend reached the United States.
ôPension plans woke to the fact that their assumptions werenÆt optimal,ö says Michala Marcussen, head of strategy and economic research at SG Asset Management in Paris. ôNo one had discounted sharp increases in longevity, which meant plans were too upbeat about what equity returns could do. Then the equities market fell and we entered a period of low interest rates. Liabilities shot up.ö
The market downturn of 2000-02 meant many pension funds moved from healthy positions to being underfunded within three years. At the same time, balance-sheet issues came to light with the scandals at Enron and other US and some European companies.
Although these cases involved fraud, they made the market aware that æsmoothingÆ the balance sheet had become a widespread practice. A new way was needed for plan sponsors to adjust to future changes in interest rates or inflation. ôPension funds and regulators realised that smoothing asset volatility can create a disconnect between valuations and the underlying economics,ö says Jim Moorem, executive vice president at Pimco and head of its LDI team in Newport Beach, California.
These events led regulators to react. ôFund rules turned employersÆ deficits into debt on the balance sheet,ö says Fergal McGuinness, senior actuary at Mercer Human Resource Consulting in Tokyo. ôPlan sponsors in the UK and the US are now figuring out how to make these up.ö
What separates LDI from old-fashioned asset-liability matching is plan sponsorsÆ willingness now to use derivatives to achieve their goals: altering the risk characteristics of a portfolio or a combination of portfolios, including æportingÆ alpha between them û not just for returns, but to reduce risk across the portfolio to protect the employerÆs shareholder equity and cash flow so that it can meet its long-term liabilities.
ôAs fund managers, we know our investment benchmarks are arbitrary,ö says James Cooper, director at Standard Life Investments in Hong Kong. ôA plan sponsor can enjoy good performance against a benchmark and yet, over time, underperform its liabilities if things like mortality rates change [see chart]. ThereÆs no product out there thatÆs a direct match to a companyÆs liabilities, but there are ways to manage the assets more in line with the actual liability needs.ö
Typical strategies that pension funds in Europe have pursued include getting the asset portfolio to better match the cash flow of liabilities, usually by lengthening the duration of its assets by buying long-term bonds or using swaps. Large exposures to equity are reduced to favour either fixed income or alternative investments. ôIf you measure your risk in terms of liabilities, then you adopt a no-loss risk approach,ö says McGuinness.
Although the concept of focusing on that final obligation carries weight, in practical terms it hasnÆt taken off in Asia. Firstly, it applies mainly to defined-benefit pension plans. So AustraliaÆs pension space û DC superannuation funds û is inured to these issues.
The only markets with a DB culture in the region are Hong Kong and Japan. In Hong Kong, however, nearly all the DB plans have been closed to new members, who instead have DC plans or fall under the (DC) Mandatory Provident Fund regime. Closed DB schemes can predict their liabilities more easily over time. In Japan the situation is more fluid, as weÆll see below.
Second, assuming a pension fund was interested, it would face some problems implementing LDI. In Hong Kong, for example, liabilities are in Hong Kong dollars. The longest duration bond in that currency is 10 years. Pension plans in the US and Europe can easily hedge 20, 30, 50 years out. If a Hong Kong entity has a 30-year liability and only a 10-year security, hedging that liability becomes difficult and expensive. And is a counterparty really going to provide a 30-year swap, when exchange rates are so unpredictable? Even the Hong Kong peg to the US dollar isnÆt a safe bet over such a long horizon.
Then thereÆs the issue that matching a long-term liability today means locking into long-duration assets at a time when bond yields are incredibly low. The very rush by European pension funds to implement LDI strategies has been one factor behind rising bond prices.
Regulatory change forced European and now American pension funds to rethink their assumptions. Those changes havenÆt hit Asian shores û yet. So pension funds see no reason why they should cut their equity exposures, and donÆt welcome the prospect of having their investments driven by accounting rules.
Some Japanese pension funds have expressed interest. Sony Global Pension Fund, in an interview with AsianInvestor in 2005, talked about restructuring its portfolio and adopting structured products and long-duration assets to shed volatility from the corporate balance sheet.
But implementing these plans has proven tricky. In addition to the problems of hedging, JapanÆs trust banks arenÆt geared to handle LDI solutions. Their systems canÆt handle running a multi-manager program with a common swap overlay, let alone the many unique swap deals that may be required. Trust banks also are challenged by using ISDA-modelled international swaps agreements or in managing collateral, and fiduciary responsibility remains a grey area.
These technical matters can be worked out if trust banks see sufficient demand, but that demand isnÆt there. LDI hasnÆt been accepted in Japan because of the countryÆs way of calculating projected benefit obligations (PBOs), which uses the average price of fixed-income investments over the past five years. In zero-interest rate Japan, that means that liabilities donÆt factor as a big deal. With rates creeping up, in fact, pension plans feel quite comfortable.
Secondly, while Japan is negotiating how to merge its accounting system with the International Accounting Standard, progress has been slow and itÆs unclear what the result will be when a deal is due in 2009. Without that certainty, Japanese pension funds are sitting tight. The DB community remains massive but has just gone through the wrenching change of daiko henjyo, and another big shift looms when tax-qualified pension plans close in 2012. Many more plans may shift to DC.
But Japan will remain a big DB market. LDI may well find a receptive audience in a few yearsÆ time once these issues have settled.
Another potential market for LDI is Korea, where employers must provide either a DB or DC scheme by 2010. KoreaÆs strong labour unions hate DC, suggesting that this market will develop a large DB universe. But the market will remain dominated by local banks and insurance companies, and at present the investment guidelines are very circumscribed, so a long-term education campaign will be required before LDI has a chance.
What does interest pension funds today, however, is absolute returns. Hong Kong plans with surpluses are in a position where they can take some risk off the table. Institutions everywhere are keen on this concept. It isnÆt LDI nor a bespoke solution, but absolute-return products may prove the thin edge of the wedge for fund managers and investment banks. And once international accounting standards do catch up with Asia, dealing with liabilities may become a priority for the regionÆs DB schemes. LDI may be DOA in Asia, but donÆt count out a resurrection.
DOA: dead on arrival. Whatever its merits, liability-driven investment is not gaining a toehold among pension funds in Asia.
This is not what fund managers and investment banks want to hear. They have built a very nice business in Europe and the United States around a sensible idea: that pension fundsÆ traditional assumptions arenÆt accurate, and therefore they are exposed to the risk that they wonÆt be able to ultimately meet their obligations. Providers and consultants are keen to introduce these ideas to clients in the Asia-Pacific region û and sell advice or products on the back of them.
So far they have been rebuffed. First: why? Second: will this change?
The answer to the second question is yes. To understand how, though, requires figuring out the answer to the first question.
There is no set definition for liability-driven investment. It can be interpreted to simply mean a more sophisticated management of beta; it can just mean a derivatives product; or it is a strategy to deal with future uncertainty about liabilities.
Some providers note that LDI is simply a dressed-up version of asset-liability matching that uses financial innovations to realise the abstractions of ALM in a practical way.
A combination of regulation, accounting-rule changes and market events forced pension plans in Europe and more recently in America to review their assumptions.
The Nordic countries were the first in 2000 and 2001 to tighten accounting rules for pension funds. The Netherlands and the United Kingdom followed in 2004, and last year the trend reached the United States.
ôPension plans woke to the fact that their assumptions werenÆt optimal,ö says Michala Marcussen, head of strategy and economic research at SG Asset Management in Paris. ôNo one had discounted sharp increases in longevity, which meant plans were too upbeat about what equity returns could do. Then the equities market fell and we entered a period of low interest rates. Liabilities shot up.ö
The market downturn of 2000-02 meant many pension funds moved from healthy positions to being underfunded within three years. At the same time, balance-sheet issues came to light with the scandals at Enron and other US and some European companies.
Although these cases involved fraud, they made the market aware that æsmoothingÆ the balance sheet had become a widespread practice. A new way was needed for plan sponsors to adjust to future changes in interest rates or inflation. ôPension funds and regulators realised that smoothing asset volatility can create a disconnect between valuations and the underlying economics,ö says Jim Moorem, executive vice president at Pimco and head of its LDI team in Newport Beach, California.
These events led regulators to react. ôFund rules turned employersÆ deficits into debt on the balance sheet,ö says Fergal McGuinness, senior actuary at Mercer Human Resource Consulting in Tokyo. ôPlan sponsors in the UK and the US are now figuring out how to make these up.ö
What separates LDI from old-fashioned asset-liability matching is plan sponsorsÆ willingness now to use derivatives to achieve their goals: altering the risk characteristics of a portfolio or a combination of portfolios, including æportingÆ alpha between them û not just for returns, but to reduce risk across the portfolio to protect the employerÆs shareholder equity and cash flow so that it can meet its long-term liabilities.
ôAs fund managers, we know our investment benchmarks are arbitrary,ö says James Cooper, director at Standard Life Investments in Hong Kong. ôA plan sponsor can enjoy good performance against a benchmark and yet, over time, underperform its liabilities if things like mortality rates change [see chart]. ThereÆs no product out there thatÆs a direct match to a companyÆs liabilities, but there are ways to manage the assets more in line with the actual liability needs.ö
Typical strategies that pension funds in Europe have pursued include getting the asset portfolio to better match the cash flow of liabilities, usually by lengthening the duration of its assets by buying long-term bonds or using swaps. Large exposures to equity are reduced to favour either fixed income or alternative investments. ôIf you measure your risk in terms of liabilities, then you adopt a no-loss risk approach,ö says McGuinness.
Although the concept of focusing on that final obligation carries weight, in practical terms it hasnÆt taken off in Asia. Firstly, it applies mainly to defined-benefit pension plans. So AustraliaÆs pension space û DC superannuation funds û is inured to these issues.
The only markets with a DB culture in the region are Hong Kong and Japan. In Hong Kong, however, nearly all the DB plans have been closed to new members, who instead have DC plans or fall under the (DC) Mandatory Provident Fund regime. Closed DB schemes can predict their liabilities more easily over time. In Japan the situation is more fluid, as weÆll see below.
Second, assuming a pension fund was interested, it would face some problems implementing LDI. In Hong Kong, for example, liabilities are in Hong Kong dollars. The longest duration bond in that currency is 10 years. Pension plans in the US and Europe can easily hedge 20, 30, 50 years out. If a Hong Kong entity has a 30-year liability and only a 10-year security, hedging that liability becomes difficult and expensive. And is a counterparty really going to provide a 30-year swap, when exchange rates are so unpredictable? Even the Hong Kong peg to the US dollar isnÆt a safe bet over such a long horizon.
Then thereÆs the issue that matching a long-term liability today means locking into long-duration assets at a time when bond yields are incredibly low. The very rush by European pension funds to implement LDI strategies has been one factor behind rising bond prices.
Regulatory change forced European and now American pension funds to rethink their assumptions. Those changes havenÆt hit Asian shores û yet. So pension funds see no reason why they should cut their equity exposures, and donÆt welcome the prospect of having their investments driven by accounting rules.
Some Japanese pension funds have expressed interest. Sony Global Pension Fund, in an interview with AsianInvestor in 2005, talked about restructuring its portfolio and adopting structured products and long-duration assets to shed volatility from the corporate balance sheet.
But implementing these plans has proven tricky. In addition to the problems of hedging, JapanÆs trust banks arenÆt geared to handle LDI solutions. Their systems canÆt handle running a multi-manager program with a common swap overlay, let alone the many unique swap deals that may be required. Trust banks also are challenged by using ISDA-modelled international swaps agreements or in managing collateral, and fiduciary responsibility remains a grey area.
These technical matters can be worked out if trust banks see sufficient demand, but that demand isnÆt there. LDI hasnÆt been accepted in Japan because of the countryÆs way of calculating projected benefit obligations (PBOs), which uses the average price of fixed-income investments over the past five years. In zero-interest rate Japan, that means that liabilities donÆt factor as a big deal. With rates creeping up, in fact, pension plans feel quite comfortable.
Secondly, while Japan is negotiating how to merge its accounting system with the International Accounting Standard, progress has been slow and itÆs unclear what the result will be when a deal is due in 2009. Without that certainty, Japanese pension funds are sitting tight. The DB community remains massive but has just gone through the wrenching change of daiko henjyo, and another big shift looms when tax-qualified pension plans close in 2012. Many more plans may shift to DC.
But Japan will remain a big DB market. LDI may well find a receptive audience in a few yearsÆ time once these issues have settled.
Another potential market for LDI is Korea, where employers must provide either a DB or DC scheme by 2010. KoreaÆs strong labour unions hate DC, suggesting that this market will develop a large DB universe. But the market will remain dominated by local banks and insurance companies, and at present the investment guidelines are very circumscribed, so a long-term education campaign will be required before LDI has a chance.
What does interest pension funds today, however, is absolute returns. Hong Kong plans with surpluses are in a position where they can take some risk off the table. Institutions everywhere are keen on this concept. It isnÆt LDI nor a bespoke solution, but absolute-return products may prove the thin edge of the wedge for fund managers and investment banks. And once international accounting standards do catch up with Asia, dealing with liabilities may become a priority for the regionÆs DB schemes. LDI may be DOA in Asia, but donÆt count out a resurrection.
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