LONDON UK fund companies that have made humble profits from hedging risk for pension funds are now finding themselves in a sweet spot for selling far more lucrative products to the same clients.
So-called liability driven investment LDI.L has focused on low-margin hedging of inflation or interest rate risk, to help Britain's 1-trillion-pound corporate defined benefit DB.L pension industry pay its retirees.
The same firms are now successfully convincing scheme trustees to redeploy risk budget saved through LDI to let their money work harder, increasingly selling higher-margin absolute return funds, equity derivatives or active fixed income funds.
"The LDI implementation bits are cheap as chips and won't make anyone any money," said one LDI specialist at a large fund firm, requesting anonymity in order to speak candidly.
"A cynic might say: 'Let's sell them a cheap LDI product and then we'll see if we can get them to buy some of our more expensive funds'," he said.
DB pension schemes have been burdened by generous terms which promise to pay workers based on final salaries, rather than on the amount their lifelong investments have returned.
Combined with increasing life expectancy, this leaves scheme funding deeply vulnerable to market shocks, and LDI, as well as longevity risk management, is designed to take the heat off sponsor companies who would have to make up any shortfall.
Recent results have shown the increasing profile of LDI, with Legal & General's fund arm LGIM reporting a 70-percent spike in assets, while Schroders linked sustained net inflows to its own nascent stab at the sector.
As LDI runs from simple hedging to a framework for deciding where pension money goes, calling the market size is tough.
BlackRock puts the volume of liabilities hedged by UK schemes at between 250 and 300 billion pounds, while LGIM estimates it at closer to 150 billion.
There was something of a hiatus in the market as the financial crisis left schemes wrestling with short-term shocks, but managers are now seeing a fresh spike in demand as trustees look again at ways to secure a less bumpy ride.
Most LDI providers are coy on the up-selling opportunity, but even less cynical voices acknowledge its potential to boost other areas of the business as LDI managers immersed in scheme strategy highlight new opportunities for growth.
Richard Watts, a director in F&C Asset Management's FCAM.L asset liability management team is keen to stress that his firm does not view LDI as a "business enabler".
"(But) from time to time clients who are LDI clients may choose to appoint us for other business... It may lead to cross-selling opportunities in other areas.
Schroders (SDR.L) has sought to muscle its way into an LDI market dominated by peers with big businesses in passive investments like index-trackers, and who are well used to employing hedging strategies for life companies.
The FTSE 100 firm had been in the running to buy LDI specialist Insight from Lloyds Banking Group (LLOY.L), sources have told Reuters, but has since organically built up the unit, that rivals say is an aggressive up-seller.
"The boundaries between where an LDI strategy starts and stops are increasingly blurred," Schroders head of LDI Andy Connell told Reuters.
He expects pension schemes to move away from equities to lower risk growth, perhaps through absolute return strategies or options which help mitigate equities risk.
Insight head of institutional business Andrew Welch said he has done LDI deals which see physical equities exposure replaced by futures or swaps, freeing up capital to target returns from elsewhere as part of a business that has "evolved materially".
Of course, there is no guarantee a pension scheme will pick the LDI provider's products in its pursuit of growth. But insiders talk of a "virtuous circle" in the more involved dealings with clients and advisers that LDI requires.
"(LDI business) may include regular and intense dialogue with trustees and consultants. You do develop very deep relationships... They won't unfairly favour you, but they do get to know you," said F&C's Watts.
Marcus Mollan, head of strategy in the pension solutions business at LGIM, is more explicit: "Any manager that doesn't offer a high quality LDI service is in danger of missing out on the overall strategy for the client," he told Reuters.
And the source who requested anonymity was under no illusions as to the future strategy for fund firms.
"Hedging of interest and inflation risk will just be a starting point... That's where we're going to see more work and more innovation from the fund management community, undoubtedly with high fees," he said.
(Editing by Sitaraman Shankar)
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