Rising rates pose challenges for closed DB schemes’ LDI portfolios

While some DB schemes are faced with the need to sell other assets to fund these requirements, there are others for which sensitivity to inflation has decreased, meaning they can reduce hedging.

Closed DB schemes hedge against interest rate rises by investing in liability-driven investment strategies, which include interest rate swaps and gilt repos. As interest rates have risen, the value of these gilt portfolios has fallen.

Collateral management

Some LDI managers are currently only providing monthly data on their LDI pooled funds, which, given the current volatility of markets, is insufficient

Frazer Morgan, Willis Towers Watson

Mercer partner Hemal Popat tells MandateWire: “The marked-to-market loss on the scheme gilt repo assets creates significant challenges in terms of collateral management for LDI portfolios.”

Schemes will also find their gilt repos and interest rate swaps more expensive to finance as the cost of borrowing has increased, he notes.

“But the collapse in the value of gilt portfolios far outweighs these increases in costs,” Popat adds.

The annual financing cost of gilt repos has increased by more than 1 per cent since the end of last year — due to rising interest rates — but the value of LDI portfolios has fallen by as much as 30 per cent in many cases over this period.

Aon head of LDI Dilesh Shah says: “In effect, DB schemes are using unfunded hedging by using gilt repos.”

Gilt repos work by the pension scheme agreeing to sell the gilt with an agreement to purchase it back at a later date at a pre-agreed price.

As interest rates have risen, the value of the gilts has fallen, which means a pension fund needs to make up the difference between what the scheme has borrowed and the gilt’s value by posting collateral, Shah explains.

For most schemes, transferring additional collateral into this portfolio will be a relatively straightforward exercise.

Popat notes: “Many schemes have a ‘waterfall’ to source extra collateral for the LDI portfolio, but some schemes may find they need to sell off equities or credit to realise this capital.”

Shah adds: “Larger schemes have the necessary governance structure and have sorted out the necessary collateral waterfall, as well as figuring out their stress levels to interest rates and inflation. In addition, they probably have a segregated account which will give them greater flexibility.”

Forced selling

Smaller schemes, however, might not have such a robust governance structure or the necessary collateral waterfalls in place.

“These schemes will then need to realise cash from the growth portfolio at a time when the value of these assets is declining,” Shah says.

Given the speed of change in the current situation, it would be helpful for pension schemes to receive more frequent data.

Willis Towers Watson investment consultant Frazer Morgan says: “Some LDI managers are currently only providing monthly data on their LDI pooled funds, which, given the current volatility of markets, is insufficient.” Weekly information would be more helpful, he notes.

It is also helpful to provide that data in an Excel spreadsheet rather than a PDF so the data can be manipulated, he adds.

It might seem counter-intuitive, but the current levels of inflation have reduced — relative to 2020 — the need for inflation hedging for those schemes with a 5 per cent cap on their benefits.

That is because the sensitivity of the value of the liabilities to inflation will vary according to where forecast prices are relative to the cap.

Inflation hedging challenges

Morgan says: “When long-dated inflation is towards the middle of the range defined by the floor and the cap, the liabilities are typically treated as being more sensitive to inflation.”

In other words, if, for example, you had a capped-at-5 per cent, inflation-linked benefits payment to make in two decades and the current 20-year inflation swap curve implied inflation of 2.5 per cent, you would want more inflation hedging than you would in recent market conditions where implied inflation was above 4 per cent.

“In some cases, LDI managers do analysis on a scheme’s underlying liabilities. If the LDI manager has the required data from the scheme actuary, they could refresh their analysis of the impact of changes in inflation on the sensitivity of the liabilities in light of current market conditions,” Morgan explains.

This could help schemes to adjust their inflation hedging in a timelier manner, he adds.

In addition, LDI benchmarks are normally specified in terms of interest rate and inflation sensitivity.

“But it would be possible to set the benchmark to LPI — the capped and floored version of the liabilities — which means you could then give the LDI manager direction to act as inflation moves in and around the cap and floor rates,” he notes.

In other words, the LDI manager could then automatically add hedging as inflation approaches the midpoint, and remove it when it reaches the cap or floor levels, he adds.

This article originally appeared on MandateWire.com