As liability-driven strategies become more and more popular, the marketplace for LDI advice is getting more crowded, with providers jockeying for position.

But according to the leading players, what pension fund clients are looking for is more than a range of investment products.

"This is now very much an environment where LDI is being defined as a decision-making framework, rather than a product," says Mike O'Brien, managing director and head of institutional business, Barclays Global Investors. "That means pension schemes, consultants and banks are increasingly assessing current investment policies vis-a-vis liabilities measured on a mark-to-market basis."

BGI is one of the main players in LDI services in the UK and Europe, and alongside the UK, has a substantial client base in the Netherlands, where the new FTK regulations took effect from 1 January, obliging pension funds to present liabilities on a mark-to-market basis. Within BGI, LDI and increasingly LDI-plus strategies (where plans are looking for solutions designed to outperform their liabilities) are among the fastest-growing areas of activity with clients.

"There are two elements to the LDI solution," says Paul Bourdon, head of European pension solutions group for Credit Suisse. "First, you look to manage risk, setting up a liability matching portfolio using bonds and swaps. Then you look for a return-seeking portfolio through diversification." However, Bourdon says that foregoing any risk from the portfolio is expensive.

"If you lock in risk over the long term, what you lose is the equity premium of about 2-3% compounded over, say, 15 - 20 years, and that is an enormous amount of money or costly increased contributions," he says. "Funds
should be looking for return and going into uncorrelated asset classes whilst managing their overall risks."

The need to both manage risk and achieve return is common to most asset managers, but there are many different views as to howto do this.

"Pension fund liabilities behave like fixed income investments, so managers like ourselves have to devise a strategy to immunise pension funds from interest rate changes," says Keith Patton, head of fixed income in Europe, Aberdeen Asset Management.

"They still have to deal with the problem of performance from the asset side. So we are not saying people should sell equities to buy fixed income investments. However, the interest rate exposure within the liability side can be addressed using some fixed income investments. Rather than seeing an LDI solution as a significant risk-reducing solution for pension funds as the duration gap between assets and liabilities is closed, we suggest that clients should transfer the risk on the liability side into a more diversified approach where the information ratio can be higher than a pure directional bet on interest rates."

Malcolm Jones, investment director, strategic solutions, Standard Life Investments agrees that a certain amount of risk can be desirable.

He says that one recent big trend has been the use of investment strategies containing a level of risk but more efficiency than a balanced fund strategy.

"Trustees still want to take investment risk within their pension scheme," he says. "And they need to, because mortality continues to improve, which is a major cost, and companies do not want to pay high contributions to be invested in bonds which they perceive to be poor value because yields are so low."

He says that while three years ago, swaps and cash flow products were more in evidence, now there is a more harmonised approach to investment strategy: "Pension funds are investing to improve their funding in a more risk-conscious manner relative to their liabilities. Increasingly, the marketplace is going more and more in a transaction-based direction."

"There have been three stages in the development of LDI strategies," says Stuart Morris, director life assurance and pension funds, UK & Ireland, Société Générale CIB. "First, many pension funds have needed to hedge risks such as inflation and interest rates by entering into vanilla derivative transactions or swaps. But since their liabilities last around 25 years, while their assets have a much shorter life, there is a duration gap."

Morris says it is the second phase which is much busier. This involves hedging against domestic equity exposure or branching out into alternatvie assets as a means of diversification.

"There is also some interest now in the third phase - portable alpha," says Morris. "This is a combination of the first two approaches, i.e. hedging against inflation and interest rates, selling equities and buying alternative investments. Clients then use returns from alternatives to enter into structured equity-type transactions in the form of swaps. This gives them an enhanced yield with little volatility. At Société Générale, we are working mainly on the second and third phases."

As LDI strategies have developed, so has the marketplace, with consultants, asset managers and investment banks all competing for a slice of the action.

"Clearly, a lot of lines have become blurred compared with the defining lines 10 years ago," says Gareth Derbyshire, managing director in the pensions advisory group at Lehman Brothers, a relative newcomer to the LDI market. "Each of the individual parties have moved on in terms of the service we provide, but I wouldn't say we are in competition with the consultants - rather we are largely complementary."

 

e says that consultants come to the LDI problem from a different angle: "A consultant focuses primarily on strategic thinking, whereas we focus just as much on the implementation of suitable solutions."

"However, we also want to work with consultants - they have a whole range of clients, including medium and small pension funds, many of whom we might not otherwise speak to," says Derbyshire. "We want to be well-regarded by the consultants because we see them as a source of distribution of our products."

But he says one advantage of the
banks over asset managers and consultants is that they have a risk management culture and technology which can be tailored to a pensions environment.

If there is something of a "hands-
off" stance in terms of encroaching on the territory of other professionals, it also seems likely that competition between the banks themselves is intensifying.

Derbyshire says a significant number of banks have moved into the LDI marketplace over the past few years. Lehmans' own team was set up early last year. It has been recruiting aggressively and now has most of its team in place.

"We don't see ourselves as being in competition with investment banks," says Antigone Theodorou, director, investment solutions, AXA Investment Managers. "We see them more as partners, like consultants, providing solutions to pension schemes."

She says that the arrival of LDI has brought together more of the players.

"For instance, when we have a potential client, we have more of a dialogue with the consultant than before, because of the LDI approach," she says.

"Before, the asset manager might say ‘We want UK equities'. Now, it is more of a framework, more a case of understanding what the client wants and how to implement that."

Theodorou has observed notable changes within the market in the three years that LDI has been used.

"At first, there was a lot of emphasis on precision, and perhaps both asset managers and consultants over-engineered some of the solutions," she says. "Now, the focus is more on explaining the overall situation and providing a strategic solution, rather than a detailed investment blueprint. That is why there are now more pooled funds in the market, although they are not as precise as direct swaps, since they are combinations of instruments with different terms."

"The difference between asset managers such as ourselves, and the investment banks, is that with LDI you have to understand your client and their liabilities," says Jeroen Rijk, director, investment strategy, Mn Services. "You can only provide a good LDI service if you know what the client's policy is. For instance, if the pension fund provides indexation and inflation goes up, you might have a real problem. It has a major impact on how you do your liability matching, and you have to use inflation-linked swaps and bonds."

But, of course, many asset management firms are part of a much bigger banking group and many of the investment banks are offering solutions in this market.

Patton says that the client company's finance director will be involved in funding issues, because he is concerned with the balance sheet.

"Because of his role in the company, the finance director will naturally be closer to the investment banking side," says Patton. "If there is a problem in his pension fund he is therefore likely to adopt a tactical solution offered by the bank. This solution may fit one point in time but not when things change. And you need to constantly monitor an LDI strategy. This is where an asset management company differs because they will offer a fiduciary solution which will ensure the strategy is constantly monitored."

But Morris says, "The idea that asset managers give advice and we don't is old-fashioned. Everything we do is very much solution-driven. Asset managers know what is doable, but they cannot carry out the high-level analytics which banks can provide. In terms of financial products, SocGen can give pension funds everything they need."