The fallout from the September market turmoil will be “wide-ranging” for UK defined benefit schemes, with regulatory changes influencing their capacity to invest in less-liquid growth strategies, according to a new report from Bloomberg Intelligence.
Following the so-called “mini” Budget on September 23, falling government bond prices prompted a series of collateral calls from DB schemes, which some feared would lead to a “doom loop” that would crash the market.
Issues arose specifically around pension funds’ liability-driven investment strategies, designed to protect against falling interest rates. Most schemes had conducted stress tests for a scenario in which there was a 1 per cent rise in long-term gilt yields, but the 4 per cent increase exceeded the contingency plans in place.
The Bank of England announced a £65bn bond-buying programme in September in an attempt to stabilise markets.
Solutions that served pensions well during the long period of falling interest rates are being reassessed
Charles Graham, Bloomberg Intelligence
The collateral calls led, in some cases, to the fire sale of assets by DB schemes, or trustees entering into emergency arrangements to secure funds to enable them to meet these calls. In other cases, hedge ratios were reduced to avoid contracts terminating.
The report stated that after the crisis, which saw LDI funds selling £23bn of gilts in three weeks, the BoE is “pressing hard for regulatory action”.
The central bank “believes the Pensions Regulator, alongside the Financial Conduct Authority and overseas agencies, needs to ensure LDI funds can withstand high interest rates and that trustees and advisers for DB pension plans are prepared for such levels of resilience in their LDI arrangements,” it said.
Regulators also need to address issues related to operational governance, fund structures and market concentrations, the report added.
TPR published guidance for schemes on November 30 that sets out the watchdog’s expectation that liquidity buffers be maintained across pooled and leveraged LDI mandates.
Sterling-denominated LDI funds across Europe have now secured an average yield buffer of around 300 basis points to 400bp, according to the Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier.
This buffer refers to the level of yield adjustment on long-term gilts from which an LDI fund is insulated, or may absorb, before its capital reserves are depleted. LDI funds trading in the UK are based exclusively in the Republic of Ireland and Luxembourg.
“Such changes will affect how LDI investment funds operate and may change the capacity of DB pension plans to invest in less-liquid growth strategies,” the report said.
Illiquids to ‘come under review’
This is due to the fact that schemes using LDI strategies invest in derivatives – including swaps, futures and gilt repurchase agreements backed by cash and government-bond holdings – to help manage interest rate, inflation and currency risk.
As derivatives are only partly funded, the pension fund can also invest in growth strategies to boost returns, the report explained.
However, new requirements to reduce leverage within DB schemes and increase liquidity buffers will not just affect gilt holdings as funds rebalance.
“Investments using alternative growth strategies and particularly those in less-liquid assets like real estate, private equity and private debt may also come under review,” the report noted.
Bloomberg Intelligence senior industry analyst (insurance) Charles Graham said: “September’s dramatic events in the gilts market and the Bank of England’s forced intervention were always going to have consequences, with LDI funds, DB pension plans, and their trustees and advisers facing a regulatory crackdown.”
LDI funds sold £23bn of gilts during market turmoil
Liability-driven investment funds sold £23bn of gilts in three weeks during the market turmoil in 2022, with pooled funds being forced sellers, Andrew Bailey has revealed.
He noted that “leverage, liquidity buffers and the size of exposure to illiquid assets are in the spotlight”, which means “solutions that served pensions well during the long period of falling interest rates are being reassessed”.
“UK investment market consequences could be widespread given the £1.8tn size of DB pension fund assets,” Graham said.
“Yet the review comes as higher interest rates have significantly improved pension plans’ funding positions, making it easier for some to transact buy-in or buyout deals with insurers such as Aviva, Phoenix or Legal & General.”
