Defined benefit (DB) pension schemes are living through a period of rapid change. Stock markets are crashing and inflation is rising, but so are bond yields. This is having a dramatic effect on DB balance sheets. A rise in the discount rate has dramatically reduced the present value of liabilities and, for the first time in years, final salary schemes are sitting on healthy surpluses, despite the value of their assets falling.
This should be welcome news for trustees who have struggled with rising liability for almost a decade. By the end of May, the Pension Protection Fund reported that DB schemes had a combined surplus of £261.6bn, which presumably makes it easier for trustees to sleep at night than the £176.3bn deficit they collectively had to manage around the same time two years ago.
The cornerstone of liability-driven investing (LDI) is to hedge assets against interest rate rises and inflation. But how effective are such strategies when both
factors change rapidly at the same time? Is there any point in hedging against a falling discount rate? All this raises the question, does LDI still have a role to play in DB schemes’ portfolios?
Love it or loathe it
There are few topics as contested in pensions as the merit of focusing on the value of liabilities when managing assets. Advocates argue that it can be
effective in reducing the volatility of the dramatic swings in liabilities trustees have to manage. In theory, an effective hedge allows a scheme’s assets to
match any change in its liabilities. Opponents of such a strategy point to a short-term focus on liabilities is taking attention away from a pension scheme’s primary directive of paying member benefits in full and on time.
Other criticisms include using discount rates as an indicator of financial health overstates the value of a scheme’s liabilities and has contributed to the decline
of DB schemes during the past two decades, despite improvements in the value of their assets. Critics claim it has led to a misallocation of capital into relatively lower yielding fixed income assets, which could have been invested in higher returning markets.
Love it or loathe it, LDI has become part of the furniture in the DB pensions industry. Indeed, 96% of medium-sized final salary schemes employ such a
scheme, while 70% of larger schemes have implemented LDI in one form or another, Mercer says.
At the start of 2022, a third of DB schemes have hedged more than 90% of their assets, according to Mercer, and for good reason. Around half of such schemes are closed to benefit accruals with only 11% admitting new members. So in theory, assessing the present value of liabilities should be straightforward. But inflation leaping to a 40-year high had been a litmus test. With interest rate and inflation risks largely hedged, how have LDI strategies performed?
Interest rates: losing money
As so often, the devil is in the detail, but the implementation of an LDI strategy does not mean that schemes are in for an easy ride. In the first instance, while hedging protects against the risk of falling interest rates, they are costly when rates rise, as Con Keating, head of research at pension scheme insurer Brighton Rock, points out.
“By virtue of the fact that hedging interest rates in LDI involves buying gilts or going long interest rates in an interest rate swap, as long as rates are declining, it is going to make a profit,” he says. “If rates go down, gilts go up and people have been winning from their LDI strategy.
“But that doesn’t make it a hedge,” Keating adds. “What is happening now is with rates rising again, and say you are long conventional gilts and long on the fixed side of your interest rate swaps, is that you are going to be losing money – and in rather large amounts.”
But Ben Clissold, head of fixed income at USS, believes that market changes demonstrate the merits of LDI. “As interest rates and inflation move higher, the value of liabilities comes down at the same speed as the linker that hedges them comes down. So if you are a fully hedged scheme, yes the value of the
linker comes down as real rates have gone up, but it has only dropped in so far as the present value of your liabilities,” he says.
For USS, the situation is different from most other final salary schemes in that it is open and, therefore, has not fully hedged its liabilities he argues. “From our point of view, rising yields are a good thing, because we are not fully hedged,” Clissold says.
Having said that, the speed of interest rate movements has been challenging for many schemes, Clissold adds. “The pace at which rates are going up, not so much the bank rates but long-end rates as well, means there are constraints on market liquidity. The sheer speed of the move and hence the volatility has created quite difficult conditions for market participants,” he adds.
We approached The Pensions Regulator (TPR) on whether schemes should review their LDI strategy in the current environment. A spokesperson confirmed that LDI is on the regulator’s radar: “We expect trustees to monitor their scheme’s investment, risk management and funding arrangements on an ongoing basis and take action as appropriate.”
A double whammy
Inflation-linked gilts (Linkers) have always been sensitive to changes in real interest rates. While the principal value is adjusted for inflation, the price of the bond trades on inflation expectations and is generally inversely related to real yields.
This has stood schemes in good stead while real yields were low and inflation expectations high. But the Bank of England hiking rates is likely to hit returns on gilts and linkers. Yet in the case of linkers, lower inflation expectations following rate hikes could potentially offer a double whammy. It is little
wonder then that linkers are a volatile asset.
This is something that Calum Mackenzie, investment partner at Aon, has observed at the schemes he works with. “Unfortunately, there’s a big interest rate component to index-linked gilts as well,” he says.
“Also, we had high short-term inflation, so high realised inflation but long-term inflation hasn’t been nearly as dramatic. So while the real yield of these gilts has moved up quite considerably, the inflation piece hasn’t moved up nearly as much. You are seeing big moves in gilt yields and big losses in value and
pension funds are being asked for more money. And in some cases, it’s been at short notice,” he adds.
Clissold says that USS, as an open scheme, is embracing a degree of flexibility as part of its LDI strategy. “Our primary hedging assets are inflation linked government or corporate bonds. We hold a significant amount of these, but because of the size of our scheme it is difficult to do that in the UK market so we also hold TIPS or European inflation-linked bonds.
“We also have a proportion of our assets in inflation-linked emerging markets, for example, from Brazil or Mexico. They have done well this year, as you might expect. The inflation dynamic is a global phenomenon,” he adds. This means USS’ portfolio does not offer a precise hedge to match UK inflation,
says. “We are not fully hedged and we hedge by proxy. For instance, we own quite a lot of TIPS which give you inflation protection relative to US inflation, but it is a good proxy in some ways,” he says.
As of March 2021, USS had 31% of its portfolio invested in index-linked bonds, compared to around 36% for a reference portfolio.
But Keating argues that the volatility of linkers defeats the purpose of matching liabilities. “Inflation-linked gilts maturing in 2068 have had a volatility of more than 30% during the past five years. Just two days ago, the 2068 linker was at £137, now it is at £155,” Keating says, adding that this volatility makes
them unsuitable as hedges.
Another challenge pension schemes are facing refers to their use of leverage. Any asset manager trying to sell trustees a strategy of investing exclusively in high-quality fixed income would have had a hard time over the past decade because net returns would be negative.
But the appeal of LDI has always been the promise that trustees do not need to do that. A typical LDI strategy splits the portfolio into a return-seeking component and a liability matching component. Not only would this allow schemes to book returns, but the liability-matching component of the portfolio would generally employ leverage through the use of swaps or repos. This would allow the scheme to offset substantial risks using only a small proportion of assets.
These derivatives would be backed up by collateral which has been put down as a buffer if the strategy were to lose money. Smaller schemes would access such complex strategies through pooled LDI offerings and their collateral would also be pooled.
All this worked brilliantly while interest rates were low with collateral pools growing significantly. But now that rates are rising, losses are being made and collateral pools are coming under significant pressure, Keating says. “We have seen pretty much all assets fall by 20% to 30% – that means schemes will
be getting collateral calls for 20% to 30% of their repo outstanding. We will be seeing forced selling of some assets to meet those calls,” he adds.
Keating, a long-time critic of LDI, believes that the use of leverage in this context is questionable from a legal point of view. “What is going on in liability-driven investment is illegal. “Most schemes are borrowing, and borrowing is simply not allowed for these purposes,” he adds. “Section 5 of the Occupational Pension Schemes (Investment) Regulations 2005 is absolutely clear. Schemes might be using repos but they are in my opinion not a derivative but a device for borrowing and should therefore not be permitted under the Regulations.”
Keating, argues that repos are a form of borrowing and should be considered illegal under the Investment Regulations. He says that trustees could even be in breach of their statutory restrictions on the use of derivatives and in some cases on their use of borrowing.
The Pensions Regulator takes a different view. Whilst being aware of the use of leverage, it advises trustees to look out for any changes to the investment risks they expose themselves to. A spokesperson for TPR said that it was keeping an eye on a potential increase of leverage but as of late June, it had not seen any evidence of this across LDI portfolios.
TPR also recommends that schemes that are having to increase leverage will put in place a liquidity waterfall structure for their collateral requirements with support from their advisers.
The sharp rise in inflation combined with rising interest rates has put LDI strategies to the test. Fully-hedged schemes are now likely to incur significant losses. For Clissold, this does not mean LDI strategies are redundant. After all, the losses in a rising rate environment are now offset by a fall in liabilities and if rates fall again, they will continue to cushion the effects of rising liabilities. What matters is that overall, DB funding statuses have improved.
“DB schemes in the PPF universe are already in surplus now and many schemes are able to fully lock down risk. LDI will continue to go from strength to strength” he predicts.
Others, including Con Keating, remain critical. He believes that a focus on the present value of liabilities continues to be a distraction from a pension scheme’s fundamental role. “Hedging the discount rate by buying gilts does nothing to improve the likelihood of paying pensions fully when due,” he says.
Whatever the perspective on LDI, it is questionable whether every trustee that has signed up to such a strategy in times of falling interest rates expected to incur losses at the scale they are now. Trustee and investment committee meetings will see some uncomfortable conversations in the months ahead.