UK DB pensions Going green within LDI solutions
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UK DB pensions
Going green within LDI solutions
A new tool is about to become available However, as awareness of the impact of investment
actions on our planet grows, incorporating ESG allows
for trustees of UK Defined Benefit (DB) schemes to meet new (non-financial) objectives focused
pension schemes looking to incorporate on ensuring they are responsible investors contributing
Environmental, Social and Governance to a better future. Investment rationale can vary from
strong ethical beliefs to simple adhesion to a green theme.
(ESG) considerations within their Nevertheless, trustees’ primary responsibility is to scheme
investment strategies. members, and a blind focus on going green, however
admirable, cannot be pursued at the expense
The UK government is planning to issue green gilts for the of meeting members’ promised benefits.
first time, providing schemes with the option to go green
within their Liability Driven Investment (LDI) allocation. Green gilts
In this paper, we provide some background on this new Green gilts are UK government bonds where all
opportunity and set out some key considerations within proceeds are designated to specific environmental
the context of LDI. projects. With £15bn of expected issuance for the fiscal
year 2021/22, green gilts will account for less than 1% of
Executive summary the overall stock of gilts (1.5% if we take into account the
. £15bn of green gilt issuance is expected in 2021/22, Bank of England’s holdings).
with all proceeds designated to specific UK Chancellor Rishi Sunak’s intention, as per his November
environmental projects 2020 statement, is to build out a green curve over the
. Green gilts offer a straightforward way for pension coming years. The UK’s Debt Management Office (DMO) is
schemes to support environmental projects, but therefore likely to issue green bonds with different maturity
significant allocation to green gilts may clash with dates, in contrast with other sovereign issuers who (with
core LDI objectives the notable exception of Germany) have decided to first
. Incorporating green gilts within the LDI solution is likely focus on one specific maturity date to improve liquidity.
to reduce overall yield due to the impact of the green The UK government’s plan for a large subset of green
premium or “greenium” gilts signals the launch of a brand new separate asset
. Depending on the extent of green issuance across the class rather than an add-on or gimmick. However, there
curve, substituting significantly for green could reduce is a limit as to how many green gilts can be issued, and
the accuracy of the liability profile match mechanically it would take many years before they
. For those wishing to be early adopters, a modest would account for a considerable proportion of
allocation is likely to be appropriate initially and a government debt.
clear framework is required to assess the impact
on risk and return Incorporating green gilts within LDI portfolios
The key questions for trustees will be:
Investment rationale
1. Can I incorporate green gilts within our scheme’s LDI
There are a wide range of reasons behind the decision allocation without impacting the risk and return profile?
to integrate ESG considerations within an investment
2. If the answer to question 1 is no, how can I accurately
process. For many asset classes such as equity and credit,
assess the portfolio impact of going green to allow an
we believe incorporating ESG considerations can lead to
informed decision, balancing green goals with core
higher returns and/or lower risk over the long term and
LDI objectives?
therefore present financial benefits in addition to ethical
benefits. For this reason, abrdn has been incorporating First, let us consider return. Will there be a yield difference
ESG within investment processes for many years. between green gilts and traditional (non- green) gilts?
Although this is difficult to predict, looking at examples in
Europe can be a good starting point to give an indication.
abrdn.comWe note the existence of a “greenium” of around 1 to 5 03. Short-term profit
basis points (0.01% to 0.05%). In other words green bonds A lower yield today is not an indication of the forthcoming
tend to be priced higher than equivalent conventional market return. Green gilts may benefit from a strong
bonds. This richness has increased recently. imbalance between today’s large demand and an
The chart below shows the size of the yield difference insufficient supply. This could lead to further green
between green and traditional German government richness. The sterling market presents some structural bias
bonds (Bunds). that could distort market level from fair value, especially for
long dated maturities and inflation-linked instruments.
As a result, a tactical short term view may be to add to
the immediate green demand to benefit from supply and
demand imbalance and benefit from green gilts yield
compression. We do not expect pension schemes to enter
this kind of game but should acknowledge that some
market participants may try to surf the green wave. It is
also a factor that the DMO is fully aware of.
Now let us consider risk in the context of LDI; the tracking
error or basis risk between the performance of the LDI
solution and the pension scheme’s underlying liabilities.
This will be particularly relevant in the early phases of
Source: Bloomberg 31 May 2021. green gilt issuance before a full green curve is established
(green gilts issued at many different maturity points). If
So going green from a Buy & Hold perspective is likely to initial issuance is at only one or two maturity points, the
cost from a yield perspective, but is this cost sufficient to ability to substitute for green gilts within the LDI solution,
deter us from investing? The presence of the “greenium” without impacting the profile match to the underlying
may simply reflect the willingness of some investors to scheme liabilities, will be limited.
sacrifice return to meet their green objectives. However, Another angle to this is how the green issuance will
there are a couple of investment arguments to support this impact the gilt-curve used by many Scheme Actuaries to
reduced yield which may be reasonable compensation: discount pension scheme liabilities. Due to the “greenium”,
green gilts may be viewed as outliers and excluded from
01. Lower price volatility
the curve construction. Alternatively, if included in the
reen gilts may be a less volatile hedging instrument as
G calculations of the gilt-curve, the liabilities will become
green investors are more likely to invest on a Buy & Hold sensitive to the performance of green gilts. The impact is
basis. However, for LDI it is the link to the scheme’s liability likely to be small initially but could increase over time as
value which is important. We will come back to this later. more green gilts are issued. At some point it may become
appropriate to incorporate green gilts within LDI solutions
02. Lower financing costs
to match the sensitivity to green in the liabilities.
A headline yield comparison is only appropriate for the
Taking on board the points above, we believe it is
funded proportion of the LDI solution. Where leverage is
unlikely that a significant allocation to green gilts will be
employed, the cost of funding also needs to be taken into
appropriate within LDI solutions in the short term. However,
consideration for overall expected return.
schemes may wish to start small and, depending on
The scarcity of green gilts, at least in the early stages,
their specific requirements, could find a suitable solution
is likely to make the bond “special” in a repurchase (repo)
following the initial issuance of green gilts. Scenario
agreement. This means banks may be more likely to offer
analysis (as illustrated in the charts below) showing the
lower funding costs for green gilt repo compared with
yield and tracking error impact of incorporating green
traditional gilts.
gilts can help trustees make an informed decision on the
We have experienced a similar scenario recently for appropriate allocation.
ultra-long gilts (2071 maturity). Due to high demand, repo
Over time, as more green gilts are issued across the curve,
financing costs were as much as 5 basis points lower than
the tracking error vs liabilities line in the chart below is likely
quotes for other long dated gilts. However, it is important to
to flatten, allowing a higher allocation to green within LDI
recognise the difference between a reduction in the yield
solutions before material risk is observed. It is more difficult
to maturity vs lower ongoing financing costs for a much
to predict what will happen to the yield impact. Demand
shorter-term repo contract.
and supply dynamics over the next few years could lead to
tightening or widening of the “greenium”.
UK DB pensions - going green within LDI solutions 2 of 5consequences. A more sophisticated approach could be
to set a yield or tracking error target or tolerance. The LDI
manager is then expected to incorporate green where
possible but within these tolerances. It will be important to
have a transparent measurement approach.
If a scheme is invested in LDI through pooled funds, the
preference for passive and low tracking error approach
is unlikely to go well with a nascent green gilt market.
However, over time we may see investment managers
such as abrdn incorporate green gilts within existing LDI
pooled funds or launch separate green LDI fund ranges.
The latter would allow smaller pension schemes to mix
and match in line with their preferences.
Conclusion
Source: abrdn – conceptual diagrams for illustration only.
We are very much at the beginning of the green
gilt journey, with unknowns regarding timing and
characteristics of the upcoming issuance. Although
pension schemes typically hold a material allocation to
gilts within their LDI solution, careful consideration will be
required before substituting for green. Given the size of the
expected issuance over the next few years, starting small
is likely to be the only viable option for those looking to be
early adopters.
Trustees, consultants and asset managers need to work
together to build new frameworks to allow schemes
to assess the impact on core LDI objectives and make
informed decisions. Over time, depending on the extent
of the green gilt issuance, we are hopeful that all schemes
will be able to use their LDI allocation to help support the
environment.
Source: abrdn – conceptual diagrams for illustration only.
Additional reading
– what about the wider green bond market?
So you want to be an early adopter... Although 2021 will see the first green issuance by the
UK government, the green bond market globally can
In the final section of this paper, we discuss some practical
be tracked back to debt issued in 2007 by the European
considerations for those looking to implement green within
Investment Bank. The market growth has gained
their existing LDI portfolio.
momentum over the last couple of years as shown in
First you need to make sure the existing LDI guidelines and the chart below.
fund structure permit investments in green gilts.
You should consider how the asset manager is discounting
the Liability Benchmark. Will the issuance of green gilts
impact the gilt-curve used to discount these cashflows
and is this consistent with the methodology of the Scheme
Actuary? Curve construction is a whole other (very
technical) topic but decisions around market weights and
smoothing methodology will need to be reviewed.
Typically, the objective of the LDI portfolio is to match
the sensitivity of the liabilities to changes in interest rates
and inflation. Without an explicit green objective, the
LDI manager is unlikely to incorporate green due to the
reasons outlined above (yield and tracking error impact).
Incorporating a small, fixed percentage of green
(e.g. 1-10%) within the LDI allocation may be simple
Source: abrdn – conceptual diagrams for illustration only.
to implement and monitor. However, even if analysis
suggests minimal impact on yield and tracking error
today this could change over time leading to unintended
UK DB pensions - going green within LDI solutions 3 of 5Whilst green bond proceeds are allocated to a green a sector perspective, whilst gilts are 100% government-
project, the opposite does not hold true. The green bond related, green indices are equally balanced between
credit quality is fully backed by the issuer, which raises the corporate and government related issuers. Finally, the
question - is a green bond sufficient to make an issuer duration of a green index is around 8 years, which is
ESG friendly? significantly shorter than Sterling gilt indices that average
12.5 years. And let us not even talk about pension fund
This question leads to the controversial subject of
preference for inflation-linked securities, which barely exist
greenwashing that we are not going to cover in this
in green format.
paper. Nevertheless, it is worth keeping in mind that, for
the same issuer, little differentiates its green bonds from As a result, the current green bond market is not an
its equivalent non-green bonds. Both are fully supported appropriate substitute for gilts when it comes to hedging
by the full faith and credit of the issuer. As such, the green instruments. The green bond market shares a lot of
label should not be perceived as a magic wand that characteristics with the overall credit market; shorter-
makes the bond holder completely detached from the dated and non-sterling based. For the last couple of years,
legal corporate issuer. The investor should instead see the de-risking solutions have become more sophisticated, to
investment as a mark of support to the issuer in its journey include these type of credit assets, such as cashflow driven
to become a more environmentally friendly one. investing (CDI) and Buy and Maintain strategies. Currency
hedging and interest rate overlays are useful instruments
As of 31 March 2021, the main Global Green bond indices
that can tailor the credit return into a hedging asset. We
report an impressive market value of £500 billion, an
strongly support the same approach for the inclusion of
astonishing 100% increase in 18 months confirming the
green assets.
strong momentum behind green bonds. However, to
put things in perspective, the global green bond market Green gilts are here to stay, and provide encouraging
remains only a quarter of the overall stock of gilts. But is evidence of the UK government’s good intentions in terms
it the right benchmark? Are we comparing green apples of climate change. However, particularly in the early
with brown pears? days of this new asset class, we believe trustees may find
better opportunities to meet environmental objectives by
Whilst gilts are Sterling-dominated, the Euro is the main
considering other types of green bonds within their wider
currency within the green bond market, followed by USD
fixed income allocation.
(US Dollar). Sterling does not even make the top 5. From
For further details please get in touch.
Keith McInally FFA Mathias Marta
Senior Solutions Director - Pensions Investment Director - Liability Aware
keith.mcinally@abrdn.com mathias.marta@abrdn.com
+44(0) 781 867 8372 +44(0) 207 156 2302
Call charges will vary. Email is not a secure form of communication so please do not send any personal or sensitive information
UK DB pensions - going green within LDI solutions 4 of 5Important Information For professional investors only – Not for public distribution. The value of investments, and the income from them, can go down as well as up and clients may get back less than the amount invested. The views expressed in this document should not be construed as advice or an investment recommendation on how to construct a portfolio or whether to buy, retain or sell a particular investment. The information contained is for exclusive use by professional customers/eligible counterparties (ECPs) and not the general public. Issued by Aberdeen Asset Managers Limited, registered in Scotland (SC108419) at 10 Queen’s Terrace, Aberdeen, AB10 1XL, and Standard Life Investments Limited registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK. For more information visit abrdn.com GB-130821-155112-2 abrdn.com STA0821187704-001
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