Investment strategy and asset-liability management for pension schemes
Investment strategy must be consistent with the liability profile and covenant. SP4 tests ALM, duration, hedging, liquidity and de-risking, including the lessons of the 2022 LDI collateral crisis.
Principles
- Set a Statement of Investment Principles covering return, risk, diversification, liquidity, ESG and stewardship.
- Split assets into matching (bonds, LDI, gilts) and return-seeking (equities, credit, property, infrastructure).
- Measure liability duration and convexity; match interest-rate and inflation sensitivity where affordable.
- Model collateral calls under stress; hold a collateral waterfall and liquid buffer.
- Use triggers and a glide path to de-risk as funding improves.
Worked example
Liabilities are £1,000m with duration 18; assets are £800m with duration 10. If yields fall 1%, liabilities rise by about 18% (£180m) and assets by 10% (£80m), so the deficit worsens by £100m. A £400m interest-rate swap overlay with duration 18 would gain about £72m on a 1% fall, reducing the net deterioration to £28m. The hedge must be sized to the liability, not to total assets.
Traps
Hedging the accounting liability rather than the funding liability; ignoring inflation linkage; assuming LDI is risk-free; forgetting collateral and basis risk; over-allocating to illiquid assets without a cash-flow plan; treating diversification as a substitute for liability matching.