Q: What structural reforms are necessary in the long term?
A: Structural reforms include three areas – asset-liability, risk limit, and on-demand liquidity.
For asset liability, the U.K. could loosen up the liability-matching requirement. Could they lower that constraint? Definitely they could. Pension funds would do less LDI hedging. It shouldn't be thought of as the third rail that's untouchable. The tradeoff is they're exposed to more risk if interest rates drop. Lowering liability coverage constraints could reduce the magnitude of LDI margin calls.
Second, the government can encourage additional investments in liquid, rising-rate products that produce returns in rising rate environments. Investments such as energy, commodities and other products could generate gains during periods of rising inflation and rates that may offset LDI hedge losses.
I'm not saying to get rid of gilts altogether; but pension funds can reallocate some of their non-gilt assets. Cash may be generated by liquidating or margining these assets and used to meet LDI margin calls. I make the following disclosure: Advocate's Rising Rate Hedge ETF is one such rising rate product.
Q: What changes do you suggest to limit risk?
A: Limit LDI coverage from derivatives. Impose a cap on the maximum liability duration to be covered by LDI derivative hedges.
Set a minimum liquidity buffer size linked to LDI usage. Minimum liquidity buffers must cover LDI losses associated with the largest historical one-month rise in rates, with ample room to spare, and be critically linked to the amount of LDI derivatives. And these buffers must withstand market stress and update in real-time.
Finally, refill this liquidity buffer monthly.
If a pension fund's liquidity buffer drops below the minimum level at the end of the month, it must be replenished the following month. While some of the measures may already be practiced by certain pensions, the pension fund liquidity crisis illustrates the need for a uniform set of risk limits to address the systemic adequacy of pension liquidity buffers.
Q: You're calling for U.K. pensions to have on-demand liquidity?
A: Yes, and this addresses the speed of margin calls. I've worked at pension advisers, and on-demand liquidity isn't usually in the standard asset management contracts. This helps pension plans source liquidity from assets managed externally.
Structural changes to asset management mandates can help pension funds generate on-demand, intra-month liquidity from asset portfolios.
Asset managers for defined benefit plans must agree to provide on-demand intra-month liquidity to the plan amounting to a percentage of portfolio asset value.
Liquidity may be generated via uninvested cash, cash using repo/margin against existing positions, physical asset deliveries, or cash from asset sales. Liquidity must be delivered within a short window, such as two-to-three business days.
Cross-portfolio liquidity is another consideration. Pension asset managers may also be their own LDI managers. In that instance, pensions and their external managers should implement cross-portfolio liquidity between asset portfolios and LDI portfolios. This must be negotiated prior to the start of a mandate.