Optimizing Technology for Liability-Driven Investing
Plummeting interest rates spurred by the COVID crisis are making liability-driven investing (LDI) more challenging than ever. Though firms are seeing reduced returns, they must still try to find ways of ensuring they have sufficient assets to cover their liabilities. To ease some of the complexity, it’s vital to have LDI technology in place with flexibility to properly match investment and risk management processes.
Matching Assets and Liabilities
LDI is an investment strategy that has been used by insurance and pension funds for decades. Its aim is to effectively manage assets with projected liabilities in mind.
As an example, pension schemes engage in LDI to ensure they have enough assets to cover their payments to pension plan participants. For pensions, the value of future payments made to plan participants are linked to a few factors. These include interest rates, the longevity of those individuals participating in the pensions, and sometimes factors like inflation or other indices.1
Over the last several years, funding ratios for pension schemes have become increasingly volatile. And more recently uncertainty over COVID-19 is only solidifying a trend towards unpredictability. Essentially, using an LDI strategy can help pensions, insurance companies, and other firms devise a more reliable path to meeting their funding obligations, even in the face of market-related uncertainty.
Ex: How to determine funding levels
There are also regulatory issues to consider. Many LDI managers face obligations to adhere to capital adequacy and solvency requirements imposed by Solvency II and other regulations. Meeting the onerous demands of such regulations remains a significant challenge for firms throughout Europe.
From a technology standpoint, there is a good deal of complexity and specialization when it comes to the systems organizations use for LDI management. These range from home-grown, ad-hoc solutions to multiple disparate systems requiring significant integration and configuration. The problem is that asset managers typically have bespoke needs and it can be very difficult, expensive and time-consuming to adapt their technology and systems to fit these requirements.
Managing LDI Effectively
To overcome the challenges of LDI investing, many firms are rethinking their approach to technology. Increasingly they are turning to specialized LDI systems that can handle both assets and liabilities together, and provide accurate valuations, cash flow projections and risk calculations. Granular scenario analysis is also a pre-requisite, which offers visibility into how their strategy will perform under different market environments. Below is a detailed list of attributes that a good LDI solution should cover.
Risk Analysis: Interest rate, duration and inflation risk are primary risks available in most LDI solutions. However, the ability to view granular level risk, with basis point exposures to all tenors of any curve is also extremely useful as it gives you the option to bucket-out your various exposures in accordance with how your investment and hedging process is structured. In terms of credit risk, you will benefit from the ability to aggregate, simulate, and illustrate the various exposures across credit ratings, issuers and counterparties. Some firms also rely on Value-at-Risk (VaR) or Expected Shortfall (ES) to illustrate instrument and book level exposures, which are areas supported in best-in-class LDI solutions.
Inflation Exposure - FINCAD
The above image shows how FINCAD’s LDI solution analyzes inflation exposures for assets, liabilities, and the combined portfolio, where the buckets can be defined to line up with internal hedging and risk processes.
Interest Rate Risk - FINCAD
Above depicts a similar exposure analysis in FINCAD, but looking at interest rate risk, grouped to visualize the pre-trade impact before execution.
Cash Flow Representation of All Instrument Types: The ability to view your cash flows is key to understanding the riskiness of meeting your funds liability obligations. Being able to model cash flows provides LDI managers with the information necessary to best model risks that must be hedged including rate, equity, inflation and credit-linked components.
Custom Data Integration: LDI managers benefit most from a system that can calculate a wide range of analytics, as well as integrate internal or third-party data. Specifically, systems that enable you to integrate a large range of data types, such as custom trade or security classifications, issuer level exposure and limits on book level, are ideal.
Unified Assets and Liabilities: A unified view of assets and liabilities can help you understand the interrelationship between them, without adding additional layers of effort for performing ad-hoc analysis. Thus, a system that can price based off zero rates, par rates, or pre-built curves is key. This offers teams a holistic solution for LDI that takes a fine-grained approach to managing risks, while simultaneously providing an efficient workflow for asset and liability portfolio management and on-demand LDI analysis.
Powerful Curve-Building: Flexible curve building is essential to coping with changing market practices and regulations. For example, many financial firms have shifted to OIS discounting and the inclusion of collateral in investment decisions. Curve-building flexibility will continue to be imperative to meet the upcoming changes to IBOR and transition to new risk-free rates. As such, a system that provides the flexibility to build curves across multi-asset and multi-currency portfolios, while including components such as OIS discounting and CSA multi-curve discounting, is key to your success.
The criteria listed above are available in FINCAD’s best-in-class LDI solution. Using FINCAD will empower you to better understand both liability and asset-based drivers of risk and valuation. Learn more about how FINCAD helps with LDI.
1“Introduction to Liability Driven Investing,” Insight Investment: https://www.insightinvestment.com/globalassets/documents/guides/an_introduction_to_ldi.pdf