Insight: How Britain's pension scheme hedge became a trillion pound gamble
17/10/2022 08:00
(Repeats with no changes to text)
By Tommy Wilkes and Carolyn Cohn
LONDON, Oct 15 (Reuters) - It started out simply enough:
British pension schemes were looking for a way to match their
assets to future pension payments.
Schemes run for pharmacy Boots and bookseller WHSmith were
early adopters in the 2000s of an investment strategy of dumping
stocks for bonds, to shield themselves from interest rate
changes.
But fifteen years later, the strategy now adopted by nearly
two-thirds of pension schemes has ended up revolving around
financial derivatives rather than just bonds - injecting a
growing amount of risk to schemes that is only now becoming
apparent as interest rates surge.
In the so-called LDI or liability-driven investment strategy
that became popular, pension schemes would use derivatives -
contracts that derive their value from one or more assets - to
protect themselves from potential swings in interest rates. With
a small amount of capital they could gain large exposures.
There is a catch: if the derivative becomes loss-making for
the pension fund because of a change in underlying asset prices,
for example, it can be called up for more money, sometimes at
short notice.
None of this mattered for a long time and consultants
predicted in 2018 that the market would soon reach the "The Age
of Peak LDI" - it was so popular that the pensions industry was
running out of assets to hedge.
LDI assets quadrupled in a decade to 1.6 trillion pounds
($1.79 trillion) last year.
But the strategy gradually became riskier, according to
interviews with pension scheme trustees, consultants, industry
experts and asset managers. Things began to unravel as Britain's
Sept. 23 "mini-budget" sparked a jump in UK government bond
yields, driving pension funds to race to raise cash to prop up
their LDI hedges.
Those derivatives came close to imploding, forcing the Bank
of England to pledge on Sept 28 to buy bonds to calm the panic.
The scale of the money using the LDI strategy, and ever
higher borrowing through the derivatives, had amplified risks
that appeared hidden during a decade of low interest rates.
When rates began rising in 2022 and warnings about risk got
louder, schemes were slow to act, according to those
interviewed.
"I do not like the term (LDI) and never did, it has been
hijacked by consultants and has morphed into what we are seeing
now," said John Ralfe, who in 2001 led the 2.3 billion pound
Boots Pension Fund's shift into bonds. The fund didn't load up
on debt, he told Reuters.
"Pension schemes were doing disguised borrowing, it's
absolutely toxic," Ralfe said. "There was much greater risk in
the financial system than anyone - including me - would have
thought."
Boots did not respond to request for comment on Friday.
WHSmith did not respond to request for comment on Thursday.
Globally, investors are worrying about other financial
products predicated on low interest rates, now that rates are
rising.
"The so-called LDI Crisis in the UK is just the symptom of a
greater economic malaise," said Nicolas J. Firzli, executive
director of the World Pensions Council.
RISKIER BETS
In the two decades since Ralfe's time at Boots, defined
benefit pension schemes - which guarantee retirees a set amount
of pension payments - have loaded up on LDI and derivatives,
using them to borrow and invest in other assets.
If leverage in the LDI strategy was three times, for
example, it meant the scheme only needed to spend 3.3 million
pounds for 10 million pounds of interest rate protection.
Instead of buying bonds to protect against falling rates - a
key determinant of a scheme's funding position - a scheme could
cover 75% of its assets, but only tie up 25% of the money, using
the rest for other investments.
The remaining money could be chanelled into higher-yielding
equities, private credit or infrastructure.
The strategy worked, and schemes' funding deficits narrowed
because the hedges made them less exposed to falling interest
rates. Lower interest rates require pension schemes to hold more
money now for future pensions payments.
This pleased companies and regulators.
Asset managers including Legal & General Investment
Management, Insight Investment and BlackRock offered LDI funds
in a low-margin but big volume business. The FCA, which
regulates LDI providers, declined to comment.
Consultants such as Aon and Mercer pitched LDI to trustees,
while The Pensions Regulator (TPR) - the government entity
regulating pension funds - encouraged schemes to use liability
matching to narrow deficits.
Nearly two-thirds of Britain's defined benefit pension
schemes use LDI funds, according to TPR.
The strategy worked as long as government bond yields stayed
below pre-agreed limits embedded in the derivatives.
"LDI had been thought of (among clients) as a fire and
forget strategy," said Nigel Sillis, a portfolio manager at
Cardano, which offers LDI strategies.
The industry had been "a little complacent" about the
knowledge among pension trustees, he added.
The risk grew over time. A senior executive at an asset
manager which sells LDI products said leverage rose, with some
managers offering tailored products of five times leverage,
versus a maximum of two or three times a decade ago.
Pension schemes had rarely been asked for extra collateral
before 2022, and a risk-averse industry had become less prudent,
the executive said, speaking on the condition of anonymity.
TPR says no scheme has been at risk of going insolvent --
rising yields actually improve the funding position of funds --
but schemes lacked access to liquidity.
Still, the regulator this week acknowledged that some funds
would have suffered.
When yields surged in an unprecendented move between Sept.
23 and Sept. 28, pension schemes were left scrambling to find
cash for collateral. If they did not find it in time, the LDI
providers wound down their hedges, leaving schemes exposed when
yields tanked following the BoE intervention.
A small minority of schemes would have seen a 10-20%
worsening in their funding position, according to Nikesh Patel,
head of client solutions at asset manager Kempen Capital
Management.
Simon Daniel, partner at law firm Eversheds Sutherland, said
pension schemes were now arranging standby facilities with their
sponsoring employers to get cash for collateral.
WARNINGS
Risks in LDI had been flagged for years.
The Bank of England's Financial Policy Committee highlighted
the need to monitor risks around LDI funds' use of leverage in
2018, BoE deputy governor Jon Cunliffe said this month.
There were more warnings this year, especially as rates
began to soar.
Pensions consultants Mercer warned clients in June to "act
quickly" to make sure they had cash. Aon said in July that
pension funds should prepare for "urgent intervention" to
protect their hedges.
TPR had "consistently alerted trustees to liquidity risk",
CEO Charles Counsell said this week.
Yet in the slow-moving world of pension funds, where
trustees and consultants tend to draft investment strategy
shifts over years, not weeks, few funds were reducing leverage
or boosting collateral, according to consultants and trustees.
Some of the most sophisticated pension schemes were even
bulking up on LDI this year, after rates started to rise.
The Universities Superannuation Scheme, Britain's biggest
pension fund, earlier this year partly linked a decision to
raise exposure to LDI to the "distinct possibility of further
falls in UK real interest rates", against which it needed to
protect its 90-billion-pound portfolio.
Britain's 30-year inflation linked bond yield has tripled
since late June.
In a statement this week USS defended its approach, noting
it had plenty of cash to meet margin calls and that it was not a
forced seller of assets. It said it was comfortable if rates
rose and hedging became costlier.
That discussion had barely started elsewhere.
"When people talked about interest rates, all they obsessed
about was interest rates falling," said David Fogarty, an
independent trustee at professional pension scheme trustee
provider Dalriada Trustees.
"There were not many discussions about leverage either."
(Reporting by Tommy Reggiori Wilkes and Carolyn Cohn
Additional reporting by Sinead Cruise, editing by Deepa
Babington)
((thomas.wilkes@tr.com; +44 (0) 7769 955711;))