How do CDI and LDI interact?

The importance of holistic delivery

Executive Summary

Liability driven investment (LDI) portfolios aim to match the change in value of liabilities. They do not specifically target income to meet cashflow requirements. This is particularly true of pooled LDI funds, where coupons are usually retained rather than distributed as income.

By contrast, a cashflow driven investment (CDI) strategy selects assets that provide contractual income to match, as far as possible, the future expected cashflow requirements of the pension scheme.

There is a wide range of contractual income assets that can be used to match liability cashflows as part of a CDI strategy. However, precise cashflow matching of all future liabilities is likely to be unfeasible. For this reason, LDI is used to hedge any cashflows not matched at outset by CDI. Hence, LDI is often a complement to CDI.

Owing to the limited availability of inflation-linked credit, inflation-linked liability cashflows are often matched with nominal bonds. LDI then provides an inflation hedge through swaps.

When considering a self-sufficiency solution, one of the largest risk exposures will be credit risk. Default and downgrade avoidance will play a key part in the success of this strategy. Therefore, it is important to select a manager with robust credit research experience.

Depending on the level of expertise, we also see benefits in the fixed-income manager running the LDI completion portfolio. CDI and LDI strategies are deeply linked – any changes to the CDI portfolio over time will have knock-on effects on the hedging requirements for the LDI portfolio.

What is the difference between LDI and CDI?

A trustee’s primary objective is to ensure, as far as possible, that pension benefits are met as they fall due. Traditionally, many schemes have been concerned with funding level and deficit volatility, as a fall in the funding level (or rise in the deficit) results in a greater reliance on the sponsor.

On the liabilities side, the two main drivers of volatility are changes in long-term interest rates and inflation expectations. To reduce funding level and deficit volatility, many schemes have successfully implemented LDI strategies. These seek to invest in assets that will mirror the interest rate and inflation exposure within the liabilities. They therefore act as a hedge against movements in the liabilities. For example, if long-term interest rates fall, the value of the liabilities will increase, all else being equal. At the same time, the value of the LDI assets will also increase, helping to offset the increase in the value of the liabilities.

However, as a scheme matures and becomes cashflow negative, the focus shifts from a purely mark-to-market risk to the requirement for income to pay benefits as they fall due. LDI portfolios do not specifically target cashflow matching, particularly for pooled LDI funds where coupons are usually retained rather than distributed as income.

In theory, a scheme that was fully funded on a gilts flat basis could invest all assets in an LDI portfolio (unleveraged). It would target a 100% hedge and sell down the portfolio over time to meet cashflow requirements.

However, few schemes are in this situation. Many use leverage within the LDI portfolio and hedge on a technical provisions basis or with a discount rate higher than gilts. For these schemes, the decision then becomes whether to continue to employ a traditional growth/matching strategy to achieve the required return. This involves selling down assets over time to meet benefits, with resultant sensitivity to market conditions at the time of disinvestments. Or they might look for an alternative strategy.

By contrast, a CDI strategy selects assets that provide contractual income to match, as far as possible, the future expected cashflow requirements of the pension scheme. LDI typically employs only gilts and/or swaps, which have low yields. A CDI strategy can encompass a wide range of contractual income assets including investment-grade corporate bonds and private debt. These assets are higher risk than government bonds. However, importantly, because they are based on contractual income, they provide a relatively high certainty of return if held to maturity. Therefore, CDI strategies typically provide an expected return above gilts. This means a scheme employing CDI does not need to be funded on a gilts flat basis.

CDI does not, though, spell the end for LDI.

CDI still requires LDI

LDI is frequently used to hedge long-dated liability cashflows for two different reasons. First, affordability constraints may mean a scheme is limited in the amount of CDI that can be used. It therefore needs the extra return from growth assets. Second, long-dated credit may be unavailable e.g. beyond 40 years. In the case of the latter, LDI essentially allows us to secure in advance the cost of buying matching bonds, although changes in the credit spread will remain unhedged.

Due to the limited availability of inflation-linked credit, inflation-linked liability cashflows are often matched with nominal bonds. LDI then provides an inflation hedge through swaps.

As future liability cashflows are not known with certainty, there may be a shortage (or excess) of income from the CDI portfolio in any given year. For example, cash outflows may be higher than expected if members take transfer values. The LDI portfolio allows additional cash to be raised at short notice through increased leverage to meet any shortfall. Equally, any excess cash can be transferred to the LDI portfolio and used for collateral requirements, or to reduce leverage over time. This approach is most common with segregated LDI portfolios. However, in practice, a pooled fund solution could be adjusted to release cash if required, for instance, by switching from unleveraged to leveraged funds.

CDI strategies may include an allocation to non-sterling bonds for the reasons outlined in our previous article How to construct a CDI portfolio . If considering overseas assets together with hedging within a CDI solution then a proportion of assets will need to be invested in eligible collateral. This will typically comprise gilts and cash to avoid having to sell credit. This hedging can be integrated within the LDI portfolio.

Holistic delivery of CDI and LDI

When considering a self-sufficiency solution, one of the largest risk exposures will be credit risk. Default and downgrade experience will play a key part in the success of this strategy. It is therefore important to select a manager with robust credit research experience. This is particularly vital for a buy-and-maintain strategy where bonds are likely to be held to maturity. History suggests that successful credit managers can have materially healthier default and downgrade experience relative to market indices.

Given the size of credit risk exposure within the solution, the key decision is to select the right fixed-income manager. If this manager also has expertise in LDI and private credit, then there may be benefits in a holistic solution. Having a single manager for liquid and illiquid credit allows a more detailed and consistent assessment of correlations and exposure levels across both asset classes. For instance, it will help avoid over-exposure to any one sector. As an example, a large private credit allocation to commercial real estate debt could be offset by a reduced level of exposure to this sector within the liquid credit portfolio.

Having a single manager for liquid and illiquid credit also allows the manager flexibility to use the more effective implementation option for a specific credit opportunity (such as private versus public).

Depending on the level of expertise, we also see benefits in the fixed-income manager running the LDI completion portfolio. As discussed above, the CDI and LDI strategies are deeply linked – any changes to the CDI portfolio over time will have knock-on effects on the hedging requirements for the LDI portfolio. For instance, a holistic manager can seamlessly manage the impact of increasing illiquid exposure on the hedging activity over time.

There are also clear collateral efficiencies to be gained from a central collateral pool for all derivative exposures e.g. interest rate swaps, inflation swaps, foreign exchange hedging and cross-currency swaps.

Additional potential benefits of using a single manager include: a lower governance burden, lower overall fees and expenses, and clear ownership of responsibilities.

There will be circumstances where it is not appropriate to appoint the fixed-income manager for private credit and/or LDI. However, certain elements of holistic delivery may still be possible if the managers can take account of external holdings when making investment decisions, and if data feeds are refreshed regularly.