1. An introduction to Liability Driven Investment
John Belgrove
5 June 2006

2. Old Approach Vs. New Approach
Liabilities
Benchmark
Assets
Conventional
Benchmark risk
Tracking error
Liability-driven
Benchmark risk
Tracking error
Too much focus on this

3. Asset vs. Liability Cashflows: Conventional Approach

4. Asset vs. Liability Cashflows: Full Cashflow Matching

5. LDI – low risk approach

6. Low risk approach
“Risk” - possibility that assets and liabilities don’t move in tandem in response to market movements
Construct assets so that as far as practicable assets move in line with liabilities in response to changes in market conditions

7. Asset v liability cashflows
Pure bond solution in previous slide
is very lumpy
is short on duration

8. Introduction to swaps
A swap can be thought of as a positive holding in one asset and a negative holding in another
We construct swap to
PAY AWAY to counterparty the cashflows from the bonds (or cash) actually held
RECEIVE from counterparty the cashflows that (as far as practicable) replicate liability cashflows

9. No swap overlay Bond receipts Pension payments Cash inflows
Cash outflows
Pension payments
Source: Barclays Capital

10. With swap overlay Swap receipts Swap payments Cash inflows
Cash outflows
Swap receipts
Swap payments
Source: Barclays Capital

11. What do swaps add?
Can be more bespoke – can construct in many flavours, which aren’t readily available in physical space
Zeroes
fixed/real/LPI
Currency
Address lumpiness of bond portfolio
Mitigate (not fully) short duration in bond portfolio

12. Pitfalls of using swaps

13. Understanding
Trustees don’t understand what can often be a complex solution
Mistaken belief that they are fully hedged
Surprise on seeing volatility from quarter to quarter
Consultants need to explain the residual risk and manage expectations
Typical problem – match not close enough; or some sort of basis risk

14. Nature of swap market To implement LDI need
at the very least, vanilla swaps, both
LIBOR to fixed
Inflation
possibly something more exotic
LPI 0 to 5
LPI 0 to 2.5
etc
Hedge fixed payments with LIBOR to fixed
Hedged pure IL payments with inflation
Can hedge hybrid pension increases with either a dynamic mix or an exotic

15. Nature of swap market Vanilla LIBOR to fixed very liquid
many banks in market
transparent pricing (Bloomberg quotes etc)
narrow spreads
easy to get in and out
Vanilla LIBOR to fixed standard product – get Bloomberg quotes

16. Nature of swap market Vanilla inflation
fewer players (say 4 or 5; 2 dominate)
limited scope to diversify counterparty risk (albeit limited due to collateralisation)
but fairly liquid

17. Nature of swap market Exotic as previous slide but more so
LPI 0 to 5 becoming more liquid
anything more fancy still illiquid
less transparency
wider spreads
harder to unwind

18. Role of banks; supply of suitable swaps
Bank seeks to find natural counterparty
aim that your pay leg is A N Other’s receive leg
aim that your receive leg is A N Other’s pay leg
bank hedges residual risk
the lower that risk, the better terms they can offer
partly why vanilla swaps more liquid
terms can vary depending on availability of “other side”
Bank is middleman – always looking for someone to take other side – to extent not possible, it hedges position
If find someone to take both sides can price a lot keener
If not, there will be bigger spread – so exotics tend to be more expensive
“Other side for fixed” -
“Other side for inflation” – utility companies

19. Suitability of match Vanilla swaps give less precise match
pure inflation swap doesn't hedge vs deflation
“manufacture” hedge from fixed and inflation
hedge sensitive if cap/floor near inflation level
so hard to hedge e.g. LPI 0 to 2.5
Exotic swaps give closer match – still not perfect
how do you match future retirees?
Either kind offers substantially longer duration than physical assets (but can still be short)

20. Basis risk Be clear what is meant by “liabilities”
Example – one client sought to manage volatility of FRS17 funding level
AA physical plus swap overlay
residual noise due to volatile AA/swap spread
This is arguably accounting tail wagging strategy dog
If you go down this road it makes sense to measure assets and liabs consistently
Term structure rather than flat

21. Swaps and high return strategy
Suppose you execute a swap to turn liability cashflows into LIBOR
If achieve LIBOR on the physical, and liability cashflows pan out as expected you’re fine
Risk of not getting LIBOR on the physical – e.g. if put swap overlay on equities
At total scheme level can argue that equity noise swamps the risk reduction given by the swap – swap approach overengineered?
Two points
If put swap overlay on EVERYTHING (equity as well) – tacitly assuming achieve LIBOR on everything
Case for not putting overlay on equity (opinions divided)

22. Risks: Removable Risks
Interest rate risk
Inflation rate risk
Duration risk
Convexity risk (full cashflow matching)
Counterparty risk (via daily marking-to-market), although not completely removed (replacement risk)

23. Risks: Non-Removable Risks
Reinvestment risk for the very long-dated liabilities(>50y)
Salary inflation risk for active liabilities
Demographic related risks (mainly longevity risk)
Change in benefit payments
Change in membership (withdrawals, redundancies, etc)
Covenant risk – Company default on payments
Contributions above/below benefit accrual
Actuaries valuation assumptions (yield curve risk)
Data risk (cashflow model)

24. Possible Structures: Active Approach
Equities (60%)
Expected return net of fees (in excess of gilts)
4.3%
Risk vs LDI
11.0%
Market Risk
80%
Manager Risk
20%
Unconstrained UK Equities
30%
Unconstrained
Global Equities
30%
Bonds (25%)
Passive
Corporates
25%
Liquidity 1
Very Liquid 2
Fairly Liquid 3
Fairly illiquid 4
Very illiquid 
Alternatives (15%)
Property 5%
Private Equity 5%
Active Currency 5%
Monitoring Commitment
Low
Medium
High 

25. Attribution: Change In Funding Level

26. Any Other Questions