REVIEW OF FINANCIAL MARKETS


LIABILITY-DRIVEN INVESTMENT – THE FINAL ROUNDUP


BRITAIN’S GILT MARKET DRAMA IN SEPTEMBER 2022 DROVE DOWN THE VALUE OF RETIREMENT SCHEMES BY AS MUCH AS £500 BILLION. WHAT LESSONS WERE LEARNED?


Dr Iain Clacher and Dr Con Keating, long-time contributors to the CISI’s thought leadership in the worlds of fixed income and pensions, were at the heart of the drama that stemmed from the then UK government’s ill-fated economic policies under its short-lived prime minister Liz Truss. In this major contribution to our thinking on retirement provision, they analyse the fault lines in long-accepted funding arrangements.


Dr Iain Clacher is professor of pensions and finance and Pro Dean International at the University of Leeds. I.Clacher@leeds.ac.uk


Dr Con Keating is head of research at Brighton Rock Group and a long-time member of the CISI Bond Forum Committee con2.keating@brightonrockgroup.co.uk


Liability-driven investment (LDI) has become the catchall, portmanteau expression for a wide range of defined benefit (DB) pension scheme investment strategies, with the only- too-predictable result of confusion and even deliberate misrepresentation. In this article, we shall endeavour to disentangle some of the intertwined threads of different strategies and the arguments revolving around them.


MATCHING The practice of buying bonds to match the contracted or projected future payment obligations of a company is as old as the hills. A portfolio constructed to achieve this objective is sufficiently commonplace that the technique has acquired a name – ‘dedication’. In the early 1980s, the high levels of


interest rates prevailing in the international bond markets saw much activity from companies looking to retire their old low coupon outstanding issues, which were trading at very deep discounts to par value in the markets. It was simply not possible just to buy


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these bonds in markets as trading was rather thin. One contributor to this thinness was that many holders were constrained by the prevailing accounting standards from selling, as the realisation of prices lower than their book values would result in charges to the holder’s profit and loss account. The technique of dedication involved


no more than buying a portfolio of government securities, usually strips,1 whose contractual payments matched those due under the company’s outstanding bond. The company would then place the securities bought into an escrow account from which funds could only be withdrawn to meet the company’s specific payment obligations under the bond’s indenture. The motivation for the company to do


this was firstly that this arrangement offered after-tax returns which were competitive and often superior to the returns available to them from further investment in their business activities. The question of realisation of the profits from these operations in the company’s accounts, over time or in a single lump sum, seemed to lie entirely at the discretion of the company’s auditors, and it was this discretion that provided secondary motivation. Once these arrangements were completed, the outstanding company bond issue ceased to appear in published company accounts. The process had also acquired a name – ‘defeasement’.2 Over time, the range of securities that


might be used to offset a company’s bond obligations was in practice widened to include agency securities and even high credit quality corporate bonds. The limits of which securities were and were not suitable lay again at the auditor’s discretion. The widening of the range of


securities employed brought with it the risk of default by the obligor, and with that failure to match cash flows. In 1975 even the possibility of default by the UK on its sterling debt obligations (gilts)


was being openly discussed in the international bond markets. Some high-grade sterling-denominated corporate and multilateral development bank bonds traded at persistently lower yields than gilts. The overarching problem with this


pairing of security and debt obligation was its cost; it was expensive to acquire the matching portfolio. In recent times, the Boots Pension


// THE BOOTS PENSION SCHEME IS OFTEN CITED AS AN EARLY EXAMPLE OF MATCHING LDI //


Scheme has acquired the (unwarranted) status of posterchild for matching using government bonds to meet pension obligations and is often cited as an early example of matching LDI. In 2001/02 the Boots Pension Scheme sold its diversified portfolio of assets and was, according to legend, invested solely in gilts. In fact, derivatives were used to ‘match’ some index-linked characteristics, and that takes the strategy into a different and riskier class of LDI. Nonetheless, the cost of implementing the strategy became obvious and in 2007, Boots’s new private equity owners, Kohlberg Kravis & Roberts, had to agree to pay £418m in deficit repair contributions3 (over ten years) to plug what was then described by commentators as “the retail and pharmaceutical


group’s pension hole”, just six years after the gilts switch. By 2010, the Boots schemes had closed even to future accrual. There is an important shift to


consider when moving from the defeasance of corporate debt obligations, where these obligations are


1Even though strips and zero-coupon government bonds did not


gain widespread usage until the early 1980s, the use of depositary receipts as claims on specific coupons or principal amounts of government securities was quite common, for example, in the syndicate accounts within the Lloyd’s American Trust Fund.


2


See: OECD Glossary of Statistical Terms - Defeasement Definition


3


Source: ‘KKR agrees deal with Boots’ pensioners’ Financial Times, 19 June 2007.


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