Could gilt market shock push schemes towards insurers over LDI?

The Bank of England intervened on September 28, reversing its planned quantitative tightening to stabilise the markets with a round of government bond purchases. 

Yields had risen significantly since the fiscal statement on September 23, which had significant impacts on the pricing of long-dated government debt, much of which is held by pension schemes. The value of the pound had also fallen against the dollar, though it has since recovered.

The central bank committed to buying bonds at a series of auctions lasting until October 14. It will then proceed with planned gilt sales on October 31. 

Altogether, the market dynamics are likely to still result in a very busy de-risking market, but where a number of transactions are reassessed with some slowing down and some accelerating

Iain Pearce, Hymans Robertson

The market shift had a significant impact on pension scheme funding. Some 72 per cent of the £1.5tn in assets held by UK schemes were invested in bonds last year, of which, 24.6 per cent was held in government fixed interest bonds.

Rising gilt yields lead to falls in scheme liabilities. A 0.3 per cent rise in the former reduces aggregate liabilities by 5.6 per cent. 

However, schemes that hedged against interest rate risk using gilts or derivatives will also have seen their gilt asset values fall, while those that did not hedge will have emerged in a stronger position.

The market shock led to questions being asked of LDI strategies, and the Pensions Regulator’s role overseeing them. TPR suggested that most schemes had the necessary protections in place to handle a market crisis, but the Work and Pensions Committee has asked whether the regulator should have “taken stronger action” in monitoring LDI strategies. 

Cardano chief executive Kerrin Rosenberg has suggested the crisis could be a seen as an argument for greater involvement by TPR, though Dalriada Trustees director David Fogarty, and Sam Roberts, director of investment consulting at Cartwright, were cool on that suggestion in a forthcoming Pensions Expert podcast.

What happened to LDI?

At an XPS webinar on October 3, Simon Bentley, Columbia Threadneedle head of UK client portfolio management, explained that pooled funds saw their value fall in line with the their scheme liabilities, which triggered a number of thresholds monitored by asset managers, leading them to call up additional assets from clients to top up collateral.

“However, what we saw on Monday or Tuesday last week, with the really extreme moves, and the speed of those moves, was that not only did we go through those initial core points where we were asking for additional capital, but we were getting to points where if that capital hadn’t arrived, then we’d have to reduce exposure for some clients,” he explained.

“The thing we were focusing on behind the scenes was looking to retain hedging positions for clients wherever possible. But there were a minority of cases where if capital hadn’t arrived for clients, by the time we got to those stop-loss thresholds, we will have reduced a small amount of exposure for those schemes. Now, what then happens is once that capital subsequently arrives, that hedging is reinstated.”

XPS chief investment officer Simeon Willis compared the LDI experience to a “seatbelt injury”, incurred during the crisis but “much more minor compared to the issues that LDI is actually protecting you against — huge swings in interest rates and inflation that [have] been very costly to schemes over so many years”. 

“We shouldn’t consign LDI to the dustbin, we should just learn from what last week has told us about market movements surprising us and capture extra safety margins when we’re employing LDI,” he said. 

“Perhaps lower leverage levels, perhaps some extra safety mechanisms within the funds, some sort of revolving credit facility to give us a source of last-minute liquidity when needed — there’s various things that we can do in LDI.”

Are insurers preferable?

Fitch Ratings suggested, on October 5, that the fallout from the crisis could drive schemes away from LDI strategies and toward insurers, because of the need to put up large amounts of extra collateral.

“The crisis highlighted the risks of LDI funds that make substantial use of derivatives, and we believe pension schemes’ appetite for LDI solutions will be greatly reduced as a result,” it said. 

“In particular, demand for leveraged LDI structures will have been dealt a severe blow. We also expect pension schemes to be warier of untested non-insurance pension consolidators due to heightened risk aversion.”

LDI funds falling out of favour could lead to increased interest in buy-in and buy-out deals, it continued. Under the former, the insurer makes payments to the scheme to cover future pensions, while under the latter the insurer makes payments directly to scheme members.

“Pension derisking through insurers involves less risk than LDI funds. Pension funds or pensioners are still exposed to the risk of insurance companies failing, but insurers are subject to substantial capital requirements, including a requirement to match long-duration cash flows with suitable assets,” Fitch explained. 

“In addition, insurers hold strong liquidity buffers, which are stress-tested for various scenarios, including recent market events. We expect insurers’ liquidity positions to have comfortably withstood the recent gilt market volatility, despite the investor concerns implied by the companies’ share price movements.”

In a blog post, Iain Pearce, Hymans Robertson’s head of alternative risk transfer, agreed that the market shock would have an impact on the deriskng market, albeit not in a uniform direction.

“Schemes that have been moving steadily towards full funding on buy-out will typically have a de-risked portfolio that is designed to ultimately pay the buy-out premium (either transferred to the insurer or sold for cash), and will be well hedged to movements in interest rates with low levels of leverage,” he explained. 

“As a result, they are well placed to weather the current volatility. However, the material changes in yields will magnify any differences in hedging strategies between the insurers and schemes and so could create an unwelcome headwind for those schemes that were very close to being able to transact.”

Of those schemes that were further away from buy-out, and that were under-hedged to interest rates, he said they would have seen a “rapid improvement” in their funding levels that would likely see them “executing plans to lock in these gains and accelerate their preparations for buy-out”.

Some schemes may have been targeting a partial buy-in instead. These are schemes that, typically, have a mix of growth and hedging assets.

“Usually the hedging part of the portfolio will include at least some leveraged LDI assets, which have mirrored the rapid falls in the value of long dated gilts and swaps. Whilst funding levels may not have been impacted, the hedging assets that were set aside to fund the buy-in may now be required as collateral within the LDI portfolio,” he wrote.

In these examples, recent events may lead schemes to review their planned buy-ins, and perhaps either defer them or reduce them in size.

“Altogether, the market dynamics are likely to still result in a very busy… de-risking market, but where a number of transactions are reassessed with some slowing down and some accelerating. Overall, we would expect these changes to further the trend where buy-outs make up an increasing share of the overall market,” he said.