The Pensions Regulator should consider regulating levels of liability-driven investments leverage to guarantee that pensions schemes can withstand future market volatility, experts have warned.
The Bank of England announced on September 28 a £65bn bond-buying programme in an attempt to stabilise markets, after falling government bond prices prompted collateral calls for pension funds.
Government bond prices collapsed and yields rocketed after the government’s “mini” Budget on September 23, which pledged extensive tax cuts for businesses and high earners.
Before chancellor Kwasi Kwarteng’s Budget announcement, UK 10-year gilt yields sat at just under 3.4 per cent. They have since risen to almost 4.6 per cent, dropping briefly below 4 per cent following the BoE’s announcement.
I’m not aware of pension funds that are doing anything reckless, but that doesn’t mean there isn’t a case for regulation
Kerrin Rosenberg, Cardano
LDI is a risk management tool used to protect schemes from adverse movements in interest rates and ensuring that funding levels do not deteriorate when interest rates fall.
Pension schemes will have plans in place so that if interest rates rise, they are required to post collateral, and typically conduct a stress test against a 1 per cent rise in long-term gilt yields.
While schemes have generally coped with the additional capital calls required, an increase of gilt yields to 4 per cent went beyond the contingency plans that most schemes had in place, creating stress within the financial system and dictating the need for the BoE intervention.
It is common for schemes to introduce leverage into their LDI portfolios to free up capital to invest in growth assets, and in the case of an interest rates rise — where liabilities and asset values fall — this leverage will increase.
As a result, the LDI fund manager will require additional capital to reduce the leverage to the original level.
The case for regulation
Cardano chief executive Kerrin Rosenberg — one of the people who alerted the BoE to the issue — told Pensions Expert that “there is a place for some regulation on the level of leverage in pension funds”.
He said: “There’s a lot of regulation about the use of derivatives for pension funds, a lot of regulation about banking counterparties and derivatives management, there is a lot of reporting and visibility on derivatives, but there’s nothing stopping a pension fund [from] being reckless in the degree of leverage that they use.”
Rosenberg noted that “banks are required to hold a certain level of deposits depending on the size of their customer base”; however, in “the UK pensions industry there isn’t a strict maximum leverage number that has been calculated”.
“I’m not aware of pension funds that are doing anything reckless, but that doesn’t mean there isn’t a case for regulation,” he added.
LCP partner Dan Mikulskis noted that the “question of the right level of leverage is the key one at the moment”.
He said managers, consultants and trustees are “addressing this question right now, to ensure their LDI programme is robust and doesn’t get adversely affected in future market volatility”.
“Regulators may also want to view it from the perspective of systemic importance,” Mikulskis added.
In a webinar on October 3, XPS Group chief investment officer Simeon Willis pointed out that one of the consequences of the liquidity challenge which led to the BoE intervention will be “a reduction of leverage within LDI mandates”.
He noted, however, that this is consistent “with the direction of travel for the industry anyway, because as schemes move along that journey planning and get better funded, actually they don’t need that leverage and therefore you see schemes derisking and gravitating towards less-leveraged solutions”.
TPR has been approached for comment.
LDI is here to stay
Questioned about the future of LDI, all three experts agree that it is an integral part of schemes’ risk management and should continue to be a part of pension fund strategies.
Rosenberg said: “The industry has overwhelmingly concluded that running interest rate and inflation risk isn’t a good idea.
“There are a small number of naysayers who never agreed with this and have been saying for 30 years that this is a bad idea. For 29 years, they have been wrong.”
He noted that “not hedging liabilities was a silly risk to run, which was expensive and has cost sponsors hundreds of billions of pounds in contributions they didnt need to make if they had hedged their schemes earlier”.
He added: “If you look at any other financial industries, LDI hedging is not only considered normal and conventional, it’s actually the law in insurance, retail banking. There is nothing in this crisis that should cause us to rethink that.”
“We shouldn’t consign LDI to the dustbin, we should just learn from what the past week has told us about market movements surprising us, and capture extra safety margins when we’re employing LDI,” Willis argued.
TPR: Schemes had right structures in place to face market crisis
The Pensions Regulator believes defined benefit schemes had “sensible waterfall measures in place” to face the collateral calls prompted by rising gilt yields and has advised struggling trustees to speak to their advisers.
He believes some changes will be implemented by the LDI industry, such as lower leverage levels or extra safety mechanisms within the funds.
“The LDI industry has demonstrated itself as being pretty innovative when it comes to addressing challenges,” he said.
Mikulskis added: “With DB schemes being in generally good funded positions, and with a clear path to buyout, I expect trustees and sponsors to want to continue managing risk with LDI.”
