At our recent Small Schemes’ Summit, an annual event that brings together a host of small scheme trustees and discusses the key challenges they face, I asked for a show of hands for the following question:
How many people have pooled LDI or have looked at pooled LDI? About 50% of the audience raised their hands.
I then asked how many people had bought a house with a mortgage, with near enough 100% of the audience saying they had.
Finally, I asked how many had bought said house with a personal loan. The answer, thankfully, was zero.
What does it mean for LDI? In some ways, LDI is like buying a house with a mortgage. You are getting exposure to something (bonds/liability-like behaviour - however you want to describe it) that you cannot currently afford, the idea being that over time your scheme assets grow in such a way that you can ultimately afford to own the bond or liability-like asset outright.
Buying a house is exactly the same. You are getting exposure to the price of the house from day one, but you can’t afford it outright so you have to pay for it gradually over time. A bank is happy to lend you this money as it has the security of your house if you fail to pay. If you tried to borrow money with less security - in extremis, an unsecured personal loan - the bank would probably not be interested or it would be very expensive.
Pooled LDI involves getting more hedging than you invest in the pooled fund. As a pension scheme looking for return, you want to invest as little as possible in the pooled fund for a given level of hedging (as that way you retain more in growth assets).
But the less you invest in the pooled fund, the more it looks like a personal loan. After all, the only security the bank has is the assets in the pooled fund, so the bank rightly wants as many assets in the fund as possible. The pooled fund needs to balance these factors. But because its need to trade dominates (as it needs to allow investors in and out), it will err on the side of caution.
The result: pension schemes end up needing to allocate between £30 and £40 to get £100 of hedging. If you need more than 60% of your assets earning a return to achieve your long-term funding goal, then this is a problem.
So what is the solution?
Segregated mandates do not have any of the above challenges. In a segregated mandate, the bank is engaging directly with the pension scheme and has recourse to the assets if the scheme fails to pay. Therefore, it is more like a mortgage and the banks will, in all likelihood, readily trade with you. As a result, schemes with segregated mandates can comfortably have 10-20% more assets on risk than a pooled equivalent.
Many schemes may believe a segregated mandate is too complicated, but the reality is that part of the market has evolved substantially to the point where they can now be as easy to implement for many schemes as a pooled fund.
Think about a pooled fund document - it is thousands of pages of words which effectively delegates responsibility to the pooled fund. The result is that the scheme signs one bit of paper and everything happens in the background. Using the same approach for segregated documentation means that the on-boarding process can now feel as easy as that of a pooled fund, yet they have all the benefits described above, as well as more flexibility.
For those schemes reviewing their LDI or thinking of doing so, a pooled approach might not be as sensible - or as efficient - as it seems.