This is not a good time to be promoting liability-driven investment (LDI). In the current climate, an LDI pitch to a trustee board of a UK pension fund might go down as well as selling asset-backed securities in 2008 or tickets for a cruise at the height of the Covid pandemic.
The strategy has made the headlines since the end of September for the wrong reasons. The Bank of England has accused highly leveraged schemes which are invested in derivatives of posing a systemic risk to the UK’s financial sector. Not a good look for a risk management strategy.
But there is a paradox here as most of the 85% of defined benefit (DB) schemes pursuing an LDI strategy are determined to continue doing so, even at a considerable cost, judging by the schemes portfolio institutional spoke to. This raises the question: what will the future of LDI look like?
A roaring success
To understand the reticence to discard LDI, it is worth taking a look at why the strategy was first introduced. In the 1990s, changes to British accounting standards meant that pension scheme liabilities became part of corporate balance sheets. At the time, most final salary schemes were open and pension scheme liabilities weighed heavily upon corporate accounts. The joke in reference to British Airways of a pension scheme with an airline as a side business is said to date back to that period. The change in accounting rules accelerated the closure of open DB schemes and led to a shift in their portfolios from equities to fixed income.
By the turn of the millennium, DB schemes were still predominantly invested in equities, which accounted for 75% of theaverage portfolio. But a year later, the Boots Pension Scheme shocked the industry by converting its entire portfolio into high-quality long-dated gilts.
Fast forward 20 years and more than 80% of DB schemes have implemented LDI in some shape or form. But throughout the past 15 years, interest rates were at historic lows, so while bonds offered predictable returns, these returns were predictably poor.
That drove schemes increasingly into using leverage to enhance returns. As of 2019, almost half of final salary schemes had increased their leverage while the combined notional principal of leveraged investments stood at £498.5bn, according to The Pension Regulator.
Schemes also increasingly used derivatives to offset swings in interest rate and inflation risks, with swaps the weapon of choice in that they were held by more than 60% of schemes in 2019.
While the regulator is keen to stress that it does not to advocate any investment strategy, it has left itself open to allegations that it has at the very least approved, if not encouraged, the mushrooming of increasingly complex LDI strategies.
A case in point is the DB funding code consultation which closed in October. The draft proposals include a requirement of “low dependency” for DB schemes, which would require them to replace growth-oriented portfolios with fixed income assets, according to Charles Cowling, chief actuary at Mercer.
Those who follow LDI strategies argue that it has stood them in good stead for most of that period. Ian McKinlay, who spent six years as chief investment officer of the £40bn Lloyds Bank Pension Schemes, is one of them. “If you think about the severe market destruction we’ve gone through – the global financial crisis, the Brexit shock, the Covid shock and one or two other shocks along the way – LDI did well because it protected pension balance sheets and shielded the corporates from the shock of having to put more money in. “To me, LDI strategies are a roaring success,” he adds. “You can’t blame the current shock on LDI.”
But he does, however, acknowledge that excessive leverage, especially for small schemes, who were less able to respond to a rapidly changing market, has been a problem.
A case of irony
It was this use of leverage that has come back to bite investors when a sudden upswing in the long-dated yield curve sparked a flurry of collateral calls. Investors in LDI strategies were keen to stress that it was the speed of the movement, rather than the rise in yields itself, that caused problems. “The amount of cash collateral that was drawn from us in the nine months between January and mid-September was exactly the same as was drawn in the two days prior to the mini-budget and two days after,” says Barry Kenneth, chief investment officer of the £36bn Pension Protection Fund (PPF).
While the PPF has been fortunate to have enough cash to navigate this crisis, others were less lucky. Within days, schemes were faced with finding billions of pounds to settle collateral calls and, having burnt through their cash reserves, were forced to sell the liquid assets they had intended to hold to maturity.
“Most pooled vehicles cannot respond sufficiently quickly to those shocks,” McKinlay says. “They cannot move tens, if not hundreds, of billions in assets to replenish the collateral. That is not something that pension funds can turn around. They can maybe do it in a few weeks but not in hours.”
The liquidity crunch exposed an element of irony in the LDI strategy. For a risk management strategy aimed at reducing exposure to interest rate and inflation risks, it did not perform as intended when inflation and interest rates rose. Part of the reason is that the risk modelling was distorted, Kenneth says.
“Having gone through 15 years of low volatility, a lot of the stress tests that were conducted to establish the collateral you would need were being done with the volatility of the last 15 years in mind. But when you get back to normalised markets, the volatility should be higher because quantitative easing (QE) has dampened down volatility and when you unwind QE you could argue that it should go back to normal. It probably should be higher than normal because more bonds are going to come to the market,” he adds.
A letter by Bank of England deputy governor Jon Cunliffe to Mel Stride, chair of the House of Commons treasury committee, indicates the scale of the potential crisis. “Had the bank not intervened on Wednesday 28 September, a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties.”
While the £65bn bond purchase programme by the Bank of England managed to calm bond markets momentarily, Andrew Bailey, the Bank’s governor, has been clear that he intends to pursue his original plan of quantitative tightening.
In early October the Bank gave pension schemes three days’ notice that it was to stop buying bonds, with the intention to start selling them at the end of the month.
Never going to give you up
Pension funds do not typically operate on three-day deadlines. So what did Bailey’s October 14 ultimatum look like for pension fund balance sheets? The weeks following the Bank of England’s first intervention were dominated by a flurry of activity to generate extra cash and prepare for future margin calls.
While few schemes were willing to speak about this on the record, the movements on financial markets are evidence that the impact goes beyond gilts. Spreads in UK corporate bonds have widened, while equity funds reported record outflows in September. At least three property fund managers – Columbia Threadneedle, Schroders and Blackrock – have suspended institutional redemptions from open-ended funds. “We believe introducing this procedure is in the best interest of investors, allowing for an orderly sale of assets to meet redemption requests,” a spokesperson for Columbia Threadneedle told portfolio institutional.
This statement reflects a growing concern that the scramble for cash has turned pension funds into forced sellers who are now driven into selling their assets at a loss. The flipside of this dash for cash is that money market funds have collected £53bn in inflows, the Financial Times reported, while some sterling denominated money market funds saw daily inflows of up to 17% of their entire assets, according to Fitch Ratings.
These cashflows suggest that many schemes have no intention to give up on their LDI strategy but are trying to raise additional cash to secure their hedges.
Schemes are now being left with two options, says Calum Mackenzie, an investment partner at Aon. “They can either run with a reduced hedge or top up their collateral to maintain the hedge they have and that is going to be complex. It depends on the sponsor, it depends on their cashflows and how close there are to buyout,” he says.
It has been a busy couple of weeks for investors but also for trustees and consultants who are focussed on damage control, says Jessie Wilson, a professional trustee at Dalriada Trustees. “Over the last weeks, we’ve been working with our consultants across all schemes at Dalriada to ascertain what their LDI position is. “Do we need to be doing anything right now in case volatility returns? That’s not a long-term strategy. You don’t try making that in the eye of the storm. It is about risk-reduction,” she adds.
Schemes that have been in pooled LDI strategies have been more in the firing line because they were less able to respond to short-term market challenges. But Wilson is keen to stress that risk assessments should avoid generalisations and that bigger schemes are not always run more prudently than smaller ones. “This is more about a combination of funding level, hedge level and liquid collateral availability that will be key, rather than specifically size of scheme,” she says.
Wilson’s recommendation is that schemes without sufficient liquid collateral, especially pooled LDI schemes, should reduce their hedging because they cannot control the leverage levels in pooled funds. “Schemes that have to reduce hedging should be doing it in a thoughtful way, with regard to the long-term objective of the scheme rather than simply running out of collateral and being forced out of hedged positions held,” she says.
This sounds good in theory. In practice, it is hard to imagine that schemes have not been forced into rushed asset sales with little opportunity to consider the long-term funding objective.
At the time of writing, it is too early to assess the damage that these sales have done to schemes’ asset valuations. The PPF index for November will provide some important insights.
Long live LDI
While the long-term impact of the LDI crisis on DB schemes is difficult to assess, the stage they are at in their lifecycle and the macro-economic context provide some indications of what the future of LDI could look like.
There is a scenario to envisage in which LDI could survive, albeit in a much more simplified form, much closer to how it was when first implemented, predicts Shalin Bhagwan, head of pensions strategy at DWS.
This view is shared by John Ralfe, a pensions consultant and former head of corporate finance at the Boots Pension Scheme, who was at the helm of the scheme’s shift into fixed income in 2001. “There is a world of a difference between LDI and leveraged LDI. The problems we are seeing now all have to do with leveraged LDI. But it’s important not to throw the baby out with the bath water,” he says, predicting that schemes will retain their LDI strategies, but with reduced leverage.
Indeed, this appears to be the direction of travel for many schemes. While the first response to the crisis is to build up additional liquidity reserves, the longer-term strategy appears to be reducing the gearing and complexity of such strategies to cut the risk of further collateral calls.
And there are several trends which could support this process. First, interest rates are now much higher than they have been during the past 15 years, making it possible to book higher returns from fixed income investments, without the need to use leverage.
Simultaneously, higher gilt yields have massively lowered DB liabilities. By the end of September, schemes in the PPF universe collectively sat on a £374.5bn surplus. The present value of DB liabilities is a little more than £1trn, compared to £1.7trn a year earlier. This dramatically reduces the pressure on LDI strategies to produce outsized returns and, therefore, the need for leverage.
But it is important to note that this marks a big change in perspective. Just last year, more than a third of DB schemes planned to increase their interest and inflation hedges, according to Mercer.
Another factor is that most DB schemes are now closed and that more than 80% of plans are cashflow negative, a figure that is set to rise to 98% during the next 10 years, according to Mercer. The changing life cycle of DB schemes could support a trend towards simplicity, Ian McKinlay says. “Through time you should be able to reduce the level of leverage because what happens is that you get shorter-dated liabilities which are easier to hedge with physical assets. With any LDI strategy, there is a tension to be resolved between how much the scheme hedges and how much return it needs,” he says.
Regardless of which path they choose, the liquidity crisis in the gilt market will leave a lasting mark on DB scheme’s investment strategy. They will now be even less likely than before to invest in illiquid assets such as infrastructure. Fixed income will remain the weapon of choice as they approach the endgame even more rapidly than previously anticipated, predicts DWS’ Bagwan.
But there are also important macro-economic factors which will continue to present a challenge to LDI strategies. Perhaps the most important challenge is the beginning of a period of oversaturation in the gilt market. During the next 12 months, the Bank of England intends to sell £80bn worth of sovereign debt whilst the government plans for a surge in issuance to the tune of at least £200bn.
Added to that is HM Revenue & Customs indemnity of the Bank of England’s asset purchase facility. This means that losses as a result of the Bank’s gilt sales would be covered, resulting in further gilt issuance.
To this perfect storm comes the fact that DB demand for government bonds is now largely saturated. With most schemes closed and taking steps to reduce leverage, it is unlikely that they will snap up the hundreds of billions of pounds worth of new debt that looks set to enter the market next year alone.
While rising gilt yields bode well for measuring the present value of DB liabilities, the troubles in the gilt market are far from over and will continue to put pressure on LDI hedges. More importantly, a further surge in bond yields could be disastrous for the broader UK economy.
Difficult questions
While the future of LDI is uncertain, difficult questions remain to be answered.
For example, to what extent has the emergence of LDI and the focus on the present value of liabilities contributed to premature de-risking, and in turn to the premature closure of DB schemes? Could some schemes have fared better and stayed open for longer if they had simply invested in a broader array of growth assets? Should there be accountability for the losses that schemes will have booked from forced asset sales to meet collateral calls?
There are also difficult questions for the regulator to answer. For example, was it wise to encourage the use of leverage and complex derivative strategies when the Bank of England’s 2018 Financial Stability Report had already warned that the use of leverage through derivatives by pension funds and insurers could pose “a systemic risk”? These questions could inform the DWP DB funding consultation.
The jury is out on whether LDI remains the most effective form of managing swings in interest and inflation risks.
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