EDHEC-Risk Institute study shows that progress remains to be made in risk management for pension funds

Written on 24 April 2014.

EDHEC Publication

Between November 2013 and January 2014, EDHEC-Risk Institute surveyed 104 investors, to determine how LDI and DLDI strategies are used in practice and the reasons that motivate the adoption or non-adoption of such techniques.

The survey finds that LDI is popular, but in concrete terms the fund separation approach, which is consistent with the LDI paradigm, is not yet sufficiently widely applied to manage the LDI approach optimally, especially in southern European countries. In the same way, one of the key points in LDI for pension funds is hedging with respect to the duration of the liabilities, but it is not always implemented by pension funds, even though they affirm that they use LDI-type solutions.

The risk allocation approach, which has come up with innovative offerings in the area of factor investing in recent years, is gaining ground, because it contributes to a better understanding of institutional investors’ risks and diversification. From that perspective, we can see an acceleration in the adoption by professionals of concepts that are well documented in the academic world.

Too many pension funds are still more concerned with standalone performance than risk management, which explains why they favour tactical allocation or reviews of strategic allocation over risk management in ALM. On this subject, we observe a clear difference in the rates of adoption of dynamic LDI between the north and the south of Europe. Too many pension funds remain asset-only rather than ALM funds and do not take sufficient account of the impact of their liabilities in their asset allocation policy or risk management.

Among the key insights and concerns of the resulting study, “Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds? – A survey of the LDI practices for pension funds”:

80% of the respondents are fully aware of the LDI paradigm.

• Slightly more than 50% of the respondents explicitly measure liability risk through a probability of a shortfall or the magnitude of this shortfall.

Roughly 50% are not only aware of the importance of measuring and managing liability risk, but have effectively adopted the LDI approach, which encompasses an explicit focus on liability hedging that is achieved through a dedicated liability-hedging portfolio, as opposed to seeking to diversify away liability risk within some well-balanced policy portfolio.

Risk allocation, a novel approach to diversification within the performance-seeking portfolio, has already been adopted by more than 35% of the respondents to the survey.

50% of the pension fund respondents are hedging their liabilities while the rest of the respondents are still sitting on the sidelines.

Duration matching is only perceived as a desirable or a feasible target by about 60% of the respondents who express a focus on liability hedging, which implies that effective liability hedging is not always achieved, not even by those who express an interest in this objective.

Only about 40% implement a DLDI process, which requires periodic revisions of the portfolio policy.
• Most respondents do not translate the minimum funding requirements imposed by the regulation into floors on asset value: more than half of participants recognise that they operate under such constraints, but hardly a fifth of them impose bounds.

A majority of the respondents are aware of the presence of conflicts of interest between various stakeholders, while slightly less than half of the respondents have already made some steps towards an integrated approach to pension fund asset-liability management if only through attempts to adopt some form of hedging mechanism  against sponsor risk.

A copy of “Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds? – A survey of the LDI practices for pension funds” can be downloaded via the following link:

EDHEC Publication Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds? – A survey of the LDI practices for pension funds

This research was supported by BNP Paribas Investment Partners as part of the research chair at EDHEC-Risk Institute on “Asset-Liability Management and Institutional Investment Management.”

Since 2007, BNP Paribas Investment Partners has been sponsoring and working in partnership with the EDHEC-Risk Institute on how to bring academic research in asset liability management (ALM) closer to industry practices.
Within BNP Paribas Investment Partners, the Financial Engineering team and LDI specialists from the Multi Asset Solution team work on reliable ALM investment solutions for institutional clients, typically pension funds, but also other clients.
The seven year partnership with EDHEC-Risk Institute has resulted in five academic research papers highlighting the importance of dynamic asset allocation strategies designed to control short-term risk.
For more on the cooperation of EDHEC and BNP Paribas Investment Partners, click here.

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