LDI is now well beyond its 10th year for UK pension schemes but is still a relatively new topic for a lot of Trustee boards. When speaking to Trustees who are thinking of LDI for the first time there are some common misconceptions – interestingly these themes have not really changed in 10 years:
Misconception 1 – LDI is about buying bonds
LDI is about hedging the ‘liability’ (there will be a follow up blog discussing the reason for the inverted commas) risk (primarily interest rate and inflation) in your pension scheme. Yes, bonds are a way of doing this but they do so with a heavy price for many schemes – sacrificing return. Currency hedging is designed in a way so as not to disturb your underlying investment strategy. Similarly, LDI should be designed and implemented in such a way so as to not disrupt where your assets are invested. LDI, since 2005, has focused on hedging risks using derivatives, meaning that you do not have to tie up assets in low returning bonds.
Misconception 2 – LDI is complicated
Whenever derivatives are mentioned the word complexity is never far behind. If you get into the maths of it I agree with that sentiment. However, there are many things we use in our everyday lives that are significantly more complicated than derivatives but we still use them without thinking – planes, cars, microwaves, Actuarial Valuations(!) – the list is significant. That is not because we have understood the technical detail of how they work but because we know some core features of these things that make us comfortable (I have written a blog post on this). LDI and derivatives are the same. Some people may want to have a deep technical understanding of the maths but many may be happy understanding the key principles and safety mechanisms. As a result, education sessions should focus on building up the understanding from the basics rather than down from the complexity.
Misconception 3 – Implementing LDI is a risky decision
Very often implementing LDI will be treated/feel like an active decision that Trustees are making. Whilst this is a very understandable thing given how different LDI can be to some Trustees, it misses a key point. That point is that as a pension scheme, from day 1, you have been lumbered with liability risk which means you are automatically lumbered with a view on interest rate and inflation markets. Implementing LDI is actually reducing the risk that you are lumbered with. To some people LDI may feel like gambling on rates up or down – not too dissimilar to playing roulette. However, if you are playing roulette a bet on black feels risky, but it is the opposite if you already have a bet on red. LDI is the same – in itself LDI seems like a view on interest rates but actually it is reducing risk by offsetting a view that you are already taking.