Liability-driven investment survey

Long-term investment is usually focused on growth. In order to ensure that a pension fund can afford to pay a good pension to members it has to build value over 30 or 40 years through growth assets such as equities and property.

But increasingly pension funds – and other investors with well-defined long-term liabilities, such as mine rehabilitation funds – need more certainty that they will be able to meet their obligations.

Alexander Forbes introduced a liability-driven investment (LDI) survey in January, to complement its surveys of more traditional investments such as balanced funds. Sanlam, Coronation, Stanlib and Investec are in the survey, which covers investments worth a total of R44,5bn. Old Mutual has a liability-driven investment boutique which will also soon be submitting to the survey.

Boutique head Tanja Tippett says that investors tend to fixate on market-based indices such as the JSE all share index.

“But the most important index for pension funds to be keeping track of is their own liability index, which takes account of their own obligations.”

Even though markets have been buoyant over the past three years this has been more than offset by the reduction in interest rates – the number one variable actuaries consider when measuring liabilities.

Tippett says each fund going into LDI needs to construct its own liability index. The LDI manager then constructs a portfolio to track or outperform this index.

Demand for LDI is common enough for an asset manager to focus on nothing else. Colourfield Liability Solutions CEO Costa Economou says that effective LDI has been made possible by the growth of the availability of inflation-linked bonds (ILBs) over the past 10 years. “It is the only asset that provides a guaranteed hedge against inflation,” he says. “And pension liabilities are linked to inflation as they are tied to salary increases.”

Economou says that LDI managers should not look at the price of inflation linkers relative to other asset classes. “It is irrelevant as ILBs will track the liability and the investor’s objective will be met.”

There is very little coverage in the news when the yield curve of SA inflation linkers goes up or down. It is far less sexy than a crash on the JSE.

But it is arguably just as important to stakeholders of defined benefit pension funds. When the yields on inflation linkers fall, the value actuaries assign to fund liabilities increases. Economou says that by August 25 2010 the long-dated R202 linker traded at a yield 0,4% lower than three weeks earlier, leading to a 3,5% increase in liabilities. And it was a perfect storm as asset values fell; equities were down 4% over the same few weeks.

In the past, when funds needed an LDI strategy they would either buy a structured product from a merchant bank, which through hedging would immunise risk, or they would outsource the group of pensioners to a life office, which would agree to pay the pensions and automatically increase them by, say, 5%.

But the margins in both types of products were high, substantially more than an active manager would charge.

Dwayne Kloppers, an actuary at Alexander Forbes who compiles the LDI survey, says that some managers aim to add extra returns through riskier assets – the most popular way is through corporate bonds known as credits.

Stanlib head of fixed interest Henk Viljoen says a whole range of assets are used to enhance returns, including property, which has very good inflation protection characteristics as there are automatic annual rent increases.

Over one year, the added value in the survey has been from 0,11% to 3,12%. None gave returns below what was required relative to liabilities.

Kloppers says an evaluation of how managers achieved these returns is vital but it will be hard to differentiate between luck and skill for periods of less than five years.

He says it will be easier to spot bad performance as it is obvious within a year if the algorithmic solution a manager uses for LDI is ineffective.