U.K. investors warn that raising LDI buffers will lower returns

U.K. pension funds and money managers have increased their collateral buffers in light of the leveraged LDI-related liquidity crunch in September, but they warned the move might reduce investors' ability to achieve investment returns and increase reliance on corporate plan sponsors for contributions.

Written and oral evidence submitted to the government's Work and Pensions Committee, which is investigating defined benefit funds' use of liability-driven investing, shows the new measures that pension funds and their money managers are putting in place in relation to their leveraged LDI portfolios. U.K. pension funds use leveraged LDI to hedge inflation and interest-rate risks.

Following the Sept. 23 "mini-budget," U.K. gilt yields soared, prices fell and pension funds with LDI arrangements received multiple, and huge, collateral calls. Pension funds were forced to sell gilts — causing a doom loop in falling asset prices — and other liquid assets, and some also sold illiquid assets at huge discounts. The Bank of England intervened on Sept. 28, pledging to buy billions of pounds of long-dated gilts, stabilizing the situation.

A written submission by the BT Pension Scheme, London, dated November and published this month on the WPC website, said the £47 billion ($56.8 billion) pension fund sold cash, gilts and equities to meet liquidity demands.

The pension fund met all its collateral calls without having to sell inflation-linked gilts "and without recourse" to its corporate sponsor, BT Group.

However, BTPS has "become more cautious in how we manage the scheme's liquidity and (has) increased the collateral buffer to which we operate. This will position the scheme to better weather any further volatility in the gilt market but will also reduce the expected returns from our assets." A spokeswoman for in-house manager BT Pension Scheme Management declined to comment on the yield assumption now used to calculate its collateral buffer.

BTPS is targeting self-sufficiency by 2034, and warned that "if expected returns fall below this level then the scheme may need more support from BT in future valuations than previously anticipated."

On Wednesday, consultants and LDI managers gave oral evidence to the WPC on the topic of LDI.

Kerrin Rosenberg, CEO of U.K. fiduciary manager Cardano Investment, which uses LDI solutions as part of its OCIO arrangements, warned that there is a "trade-off between how safe one makes the collateral buffer, and what return one can earn on the growth assets. And the more you shore up in collateral, the less you're investing in growth. At 400 basis points, at 4%, there will be some pension funds who will have to go back to the drawing board and will have to reappraise their strategies, and at 4%-type buffer levels they may have to pare back their growth ambitions. And that will have consequences on the amount of money their sponsors will have to put in."

Moving to the extreme of no leverage and having an unlimited buffer "would probably cost the industry about £30 (billion) or £40 billion a year in extra sponsor contributions. So somewhere there's a systemic trade-off."

Guidance by the U.K. Pensions Regulator in November reaffirmed the need for pension funds to hold higher buffers for LDI-related strategies. It followed a communication from Ireland and Luxembourg regulators stating that the authorities had engaged with LDI managers during the recent volatility and seen improvements in yield buffers, taking them to 300 to 400 basis points on average. The authorities said that, given the current market outlook, they "do not consider that any reduction in the resilience at individual sub-fund level is appropriate at this juncture."

Insight Investment CEO Abdallah Nauphal, also giving evidence to the committee, said the firm was never a forced seller of gilts due to a "conservative buffer" and good communication with clients. Had the BOE not intervened when it did, however, Insight and its clients would not have been in that position, Mr. Nauphal said.

Now that executives "know that the market can behave the way it has," Insight has doubled its buffer to 4% from 2%. "So yields can rise 4% before the buffers are exhausted." Insight has £683 billion in assets under management.

Also giving evidence to the committee, Charles Prideaux, global head of strategy and solutions at Schroders, said: "We have done exactly the same." Schroders is also an LDI manager and has a total of $939.2 billion in AUM.