No end to growth in sight The UK LDI Market June 2017 kpmg.com/uk/pensions
Executive summary The Liability Driven Investment (LDI) industry continues to grow rapidly, with 908 billion of liabilities hedged by 1,808 pension schemes. Simeon Willis Head of Investment Strategy LDI s role in overall strategy What does fully hedged actually mean? It has been said that we overestimate what can be achieved in a year, and underestimate what can be achieved in a decade. In the LDI market I wonder whether we underestimate both. The growth in the market in percentage terms has been consistent and relentless. Relentless for those waiting in the hope of demand falls leading to real and nominal yields rising. With this growth has come a change in mind-set. For many the question now is when should we be fully hedged, not if. But what does fully hedged actually mean? Protecting the percentage funding level is a common target, but means the deficit is still exposed to changes in interest rates and inflation. Over the last 5 years, liabilities will have typically grown by 30% 40%: meaning assets will have needed to outperform to stand still on the value of the deficit, despite being fully hedged. As such there may be merit in looking to hedge your deficit too. Particularly as a sponsor s covenant ultimately relates to deficit affordability, not maintaining a given percentage funding level. But being fully hedged on any definition presents some new challenges. Precision becomes a primary concern, as failure to match the hedge to the liabilities can increase the deficit or even create a new deficit after full funding has been achieved. This presents a new level of challenge for consultants and providers as well as actuaries to make sure their liability valuation methods are as reliable and accurate as the market values of the matching assets held. 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with
Barry Jones Head of LDI Joe Rattenbury LDI Specialist Trends in the LDI industry We are seeing a divergence of products It is clear that the main protagonists are re-positioning their offerings for what they believe to be the next phase of LDI / risk management. Interestingly, the developments on offer take the raison d étre of LDI in two very different directions. On one side, we see managers consider what the role of LDI will be in a world of well-funded, de-risked pension schemes? Cashflow delivery appears to be the missing piece of the structuring jigsaw addressed by some new product launches and this forms the centre of their forward-looking thinking. and they may be onto a winning formula. If the insurance market doesn t have the capacity to absorb all of the schemes targeting buy out over the next 15 years or so, products that allow trustees to build their own annuity payment streams may well be the sensible alternative. On the other hand, some managers are seeking to build on their LDI platform to create other leveraged products that are unrelated to liability risk management. This can either be as a standalone product ( leveraged equity ) or combined with LDI ( LDI + equity ), both of which bring the benefit of greater capital efficiency to pension schemes. Either situation may well lead to schemes placing all of their assets with one fund manager and potentially an end to traditional active strategies. So are we set to see further asset gathering from the main LDI players, another pre-myners era of higher concentration within managers serving the pensions industry and the end of underperforming, highly paid active managers? Looking at the detail The risks facing the LDI industry With the LDI industry growing rapidly over recent years, an obvious question is whether this has created any new risks for pension schemes? In our survey, 82% of LDI managers highlight regulation as the biggest challenge facing pension schemes over 2017, and we expect this to continue. Some rules impact LDI managers directly, such as the introduction of central clearing for certain derivatives, and indirectly, such as Basel III rules affecting the attractiveness to banks of lending money to pension schemes. A key element of LDI is the use of leverage, and this is naturally an area of financial markets that draws the attention of regulators. The resilience of derivative instruments to this changing regulatory landscape provides reassurance to pension schemes, but a knock-on effect is a possible reduction in the amount of leverage that is now achievable through LDI mandates, and the cost of achieving that leverage. Whilst we have seen some LDI managers reduce leverage levels slightly, this has been offset by managers offering alternate sources of leverage for those that need it. A trend we have seen lately is for new entrants into the supply side of the repo market ranging from institutional investors, international banks and central clearing houses which have helped to offset the reduced supply from traditional UK banks. Ultimately, an approach that diversifies the source of leverage should position schemes well to manage any surprises. 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG LDI Survey 2017 3
Key headline trends No end to growth in sight: 23% 908bn 1,808 growth in liabilities hedged of liabilities hedged pension schemes using LDI Despite index-linked gilt yields falling to their lowest point this century, more and more pension schemes are using LDI as a risk management tool: the number of mandates increased by 27% over 2016, from 1,423 to 1,808. 42% of total liabilities hedged by LGIM For the first time, we have included pension schemes investing in LDI via third-party providers (fiduciary managers, platform providers) and this is now included in both our 2015 and 2016 mandate numbers. LGIM remains the largest provider: With strong growth across both their pooled and segregated offerings, LGIM have stayed ahead of the competition. LGIM, Insight and BlackRock continue to be the largest managers within segregated LDI; the same managers, along with BMO and Schroders, are the largest providers within pooled LDI. BMO in particular managed to win the largest number of new mandates over 2016 with over 100 new schemes. The largest percentage growth in mandates in 2016 came from Standard Life: showing that the LDI industry remains open for disruption. 1,206 Pooled LDI dominates: pooled mandates Pooled LDI accounts for almost all the growth in the number of LDI mandates over 2016. There are now over 1,200 pooled LDI mandates, up by 42% over 2016 and an average size of 100m of liabilities hedged. Segregated and bespoke pooled funds remain the preserve of large pension schemes with an average of 1.3bn liabilities hedged per mandate. 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with
1 in 5 segregated mandates use synthetic equity Innovation continues: We have seen the launch of new LDI funds over 2016 that combine LDI with growth assets such as equities or diversified growth funds. Whilst 1 in 5 segregated / bespoke pooled LDI mandates include synthetic equity, pooled LDI mandates have traditionally focussed solely on liability hedging. Although this has had a limited impact on headline numbers over 2016, we are seeing that innovation within the pooled LDI space continues apace with the launch of new funds that combine LDI and growth assets. 82% see regulation as the most important issue 80% expect new business to drive growth Regulation is key: Almost all LDI managers surveyed identified regulation as the most important issue facing the LDI industry in 2017. 44% of managers said the central clearing of derivatives was the most important issue facing the LDI industry, whilst a further 38% quoting other regulatory / legislative changes. Optimism continues: 80% of LDI managers surveyed expect growth in liabilities hedged to come from new business. This illustrates that the growth in the LDI market is not expected to stall. 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG LDI Survey 2017 5
2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with
LDI trends No slowdown in new mandates Whilst there was moderate growth in the number of segregated and bespoke pooled mandates of 5%, pooled funds continue to dominate the new to LDI part of the market. Given recent innovations in the pooled fund market, we expect this trend to continue into 2017. Total number of LDI mandates Number of mandates 2000 1800 1600 1400 1200 1000 800 600 400 200 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 Segregated Bespoke Pooled Growth continues Over 2016 the total notional value of liabilities hedged by LDI strategies has continued to increase, moving from 739bn to 908bn an increase of 23%. Using the level of hedging in place at the end of 2015 and the known market movements, we expect that the 168bn growth can be broadly attributed as: 77bn from new mandates (of which there were 305 new LDI mandates) and extensions. 91bn from market movements. Notional amount of liabilities hedged Notional liabilities hedged, bn 1000 900 800 700 600 500 400 300 200 100 0 2011 2012 2013 2014 2015 2016 Segregated Bespoke Pooled Triggers going out of fashion The number of mandates with triggerbased strategies has fallen for the second year running, in contrast with the quickly growing LDI market. Triggers now account for only 17% of all mandates the lowest point since we began our surveys. The trends illustrate that relatively complicated trigger-based strategies are unpopular with clients new to LDI (and potentially that clients with triggers in place are abandoning them). Number of mandates with triggers in place Number of mandates with triggers in place 350 300 250 200 150 100 50 0 2010 2011 2012 2013 2014 2015 2016 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG LDI Survey 2017 7
LDI market LDI growth continues There are now six managers with at least 100 LDI mandates, with LGIM, Insight and BlackRock being the largest managers by liabilities under management. This may reflect the fact these three managers are often used for most large, segregated mandates, whilst other managers particularly Schroders and BMO have a stronger presence within pooled LDI. Over the past 12 months, pooled LDI has dominated the growth in the number of mandates, with bespoke pooled and segregated LDI holding steady. Total number of mandates by manager Manager LGIM BlackRock BMO Insight Schroders River & Mercantile Standard Life State Street 2015 424 247 189 227 135 94 9 32 2016 519 316 306 266 156 100 42 34 Cardano Axa PIMCO Aberdeen Goldman Sachs Aviva 16 17 9 15 16 13 13 12 9 9 3 3 Total 1,423 1,808 Total notional amount hedged by manager 375 350 325 300 275 Notional amount hedged, bn 250 225 200 175 150 125 100 75 50 25 0 LGIM 2015 Insight BlackRock 2016 BMO Sc hroders Aviva River & Mercantile State Street Cardano St e andard Lif Aberdeen Goldman Sachs Axa PIMCO 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with
LDI market breakdown Pooled LDI dominates growth Pooled LDI has continued to dominate the growth in LDI mandates in 2016, accounting for 91% of the increase in the number of LDI mandates. This brings the total to 1,206 pooled mandates (up 42%), including those accessed via third party platforms. Innovation and competition remains strong within the pooled LDI market. For example, we have seen managers develop a range of different ways to get leveraged exposure to growth assets, either combined with LDI or on a standalone basis. This points to more pension schemes looking to get alternative sources of leverage, as has long been achieved within segregated mandates. Whilst pooled mandates tend to be smaller, the largest mandate this year was 1.9bn, up from 1.0bn last year. This illustrates that increasing numbers of larger clients are finding pooled LDI solutions that cost effectively meet their needs. Segregated and bespoke pooled LDI holding steady Segregated or bespoke pooled LDI has continued its recent, steady growth over the past year, adding 31 new mandates to bring its total to 602 from 571 (up 5%). Notional amount hedged in pooled mandates Notional amount hedged, bn However, the segregated and bespoke 125 pooled market remains on top for larger 100 pension schemes, and constitutes 89% 75 of the total number of liabilities hedged 50 by pension schemes. As far as market 25 size is concerned, pooled LDI remains 0 relatively small. Shares of supply within the segregated mandate segment appear to be more concentrated than those in the pooled LDI segment, with the three largest providers accounting for 87% of the segregated mandate segment, based on notional liabilities hedged. The smallest segregated mandate was 2m and the largest was c. 21bn, demonstrating that segregated LDI need not be the preserve of larger schemes. Notional amount hedged, bn 375 350 325 300 275 250 225 200 175 150 40 35 30 25 20 15 10 5 0 LGIM LGIM Insight BlackRock Insight 2015 2016 Aviva Riv BMO BMO er & Mercantile BlackRock Sc hroders Sc Cardano hroders St ate Street St ate Street Aberdeen St St Goldman Sachs e andard Lif Notional amount hedged in segregated and bespoke mandates 2015 2016 e andard Lif PIMCO Axa Axa 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG LDI Survey 2017 9
2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with
Appendix What is LDI? LDI or Liability Driven Investment has evolved a number of definitions. It captures the ethos of investing with a view to meeting your future liabilities rather than simply delivering a positive investment return. This can be achieved using approaches ranging anywhere between simply increasing duration of a gilt portfolio, to the use of a more sophisticated overlay strategy using instruments such as swaps. LDI is a key risk management tool given the impact that movements in liabilities have on scheme funding levels and deficits. For the purposes of this survey KPMG has defined an LDI mandate as one which either has some sort of liability cashflow benchmark, or uses derivatives to gain exposure to nominal interest rate, real interest rate or inflation hedging, primarily for the purpose of liability risk management. Mandates simply with broad bond or gilt index benchmarks have been excluded, as have single stock funds. Key terms? Notional Value: this is the value of liabilities whose interest rate or inflation risk has been hedged. Repo: A repo (or repurchase agreement) is a form of short-term borrowing. Pension schemes using repos will agree to sell their UK government bonds with the agreement to repurchase them at a pre-agreed future date and price. The difference between the two prices is the cost of the borrowing, or repo rate. Bespoke pooled: We have defined Bespoke Pooled arrangements as client-specific segregated mandates that are contained within a pooled fund structure. These can provide ease of access to a bespoke portfolio for schemes without lengthy legal setup and counterparty negotiation. Within the segregated data we have captured bespoke pooled mandates given the scheme-specific nature of the mandates and comparable skill sets required by fund managers. Notes We note that due to refinements in definitions within the questionnaire and reporting methodology for the asset managers, certain figures reported in previous surveys may differ in this survey. 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG LDI Survey 2017 11
Contacts Simeon Willis, CFA T: +44 (0)20 7694 4408 E: simeon.willis@kpmg.co.uk Barry Jones, FIA T: +44 (0)161 246 4278 E: barry.jones@kpmg.co.uk Editors: Simeon Willis, Barry Jones Authors: Joe Rattenbury, Siddique Khan kpmg.com/uk/pensions The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2017 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International. CREATE. CRT080133B June 2017.