One year on from the U.K.'s LDI crisis — when the announcement of a set of unfunded tax cuts sparked a dramatic period in the U.K. pension fund world and the gilt market — retirement plans are largely in a better place than they were.
The situation now is largely one of lower liabilities and thus better funding levels, and improved governance and operations around hedging portfolios — but it was a painful ride to get there.
A year ago, the U.K. was already absorbing interest-rate hikes by the Bank of England as it battled to keep rising inflation under control. From that point of view, pension funds and their advisers were reaping the benefits of the relationship between rising interest rates and falling liabilities: aggregate liabilities had already fallen by about 27% over the year ended Aug. 31, 2022, while interest rates had risen to 2.25% in September 2022, up from 0.1% a year earlier.
Funding levels improved to 127% as of Aug. 31, 2022, from 105% in August 2021, according to the Pension Protection Fund's 7800 index. That position has continued to improve and stood at 146.2% as of Aug. 31 this year.
But while rising rates were to pension funds' benefit, it caused pressure to build up in the gilt market.
On Sept. 23, 2022, then-Chancellor of the Exchequer Kwasi Kwarteng outlined unfunded tax cuts among other fiscal proposals that sent gilt yields soaring and prices plummeting. Yields jumped by about 165 basis points in a few days. Pension funds in the U.K. with about £1.6 trillion ($1.99 trillion) in liability-driven investment programs in place and interest-rate hedges, which commonly use derivatives overlays, suddenly found themselves receiving calls — in some cases multiple times a day — from counterparties demanding that they post more collateral against their hedging positions.
Some were able to pony up the cash. Many burned through their collateral buffers, in place to protect them from just this kind of event. Some were forced to let their hedging positions fall. Others found themselves scrambling to sell out of liquid assets — including gilts, thereby exacerbating plummeting prices — and then also rushing to offload illiquid assets in order to raise the cash they suddenly needed. And for some of the pension funds whose LDI positions were leveraged, the problems were even greater.
On Sept. 28, the Bank of England stepped in to backstop the gilt market. It stood ready to buy up to £65 billion in gilts over about two weeks. Gilt markets calmed, pension funds rethought their collateral buffers and regulators reinforced the needs for these enhanced measures, stipulating that LDI programs should be able to absorb a minimum 250 basis points shock in the gilt markets.
"It seems like there have been improvements in terms of the amount of leverage and the way that collateral is used by LDI managers," said Gordon Shannon, partner, co-head of the investment-grade business at TwentyFour Asset Management.
The past year has seen a number of other changes for LDI programs, sources said — some unexpected and some still to play out — but overall, they agreed that pension funds have actually taken the opportunity to increase their hedges.
"We saw some (pension funds) increasing their hedge ratios," said David Rae, managing director and head of strategic client solutions at Russell Investments. "There were a few schemes that had been waiting for that opportunity — I don't think any anticipated it would arrive in the way it did. We didn't see any reduce hedges — many (trustees are) comfortable with the role" that LDI plays in a portfolio, he said.
Retirement plan consultant and administration firm XPS Pensions has also seen an increase. Analysis by the firm found that the average XPS investment client has increased its liability hedging by 3% between June 30, 2022, and June 30, 2023.
"Whilst we had the immediate questioning of the role of LDI (in portfolios,) in fact, most pension schemes have really stuck to their guns and we've seen a level of increased hedging, which means people are doing more of it, not less of it, as a result," said Simeon Willis, CIO at XPS.
"With the improvement in pension scheme funding levels, a very prominent concern for trustees is not going back to the deficit they used to have if market conditions reverse. Schemes that had a relatively low level of hedging have taken the opportunity to ramp that up significantly," and there are also cases where pension funds had zero hedging and now are at a high level, Willis added. "The upside to members is limited to the benefits they've been promised, but the downside of having a scheme with a deficit is if the sponsor goes insolvent, they lose some of their pension. We've ended up in a great place for pension scheme members, greater security of benefits, locking in, reducing allocation to equities, to diversified growth funds, increasing allocation to credits, doing more hedging: It's worked so well that everyone's looking at this fabulous pool of money and wondering how it can drive growth for the U.K. economy – which was never really its purpose. That's a tribute to how well it's done in what it's set out to do," he said.
Another improvement among many pension funds has been a push for a review of governance standards, sources said. With pension funds receiving multiple calls for increasing amounts of cash, some were found to be lacking when it came to having the governance structure in place to quickly make decisions. That's resulted in some trustees looking for more help from external parties, such as fiduciary managers, and others improving their operations more generally, with monitoring of positions on an ongoing basis an area of focus as well as improved collateral waterfall plans — which assets would be sold and in what order should cash be needed.
Sources have also observed an overall reduction in leverage within LDI portfolios, largely for two reasons, the first in that added leverage exacerbated the issues pension funds had with collateral.
"The single biggest change to LDI portfolios, across the industry, is that more highly leveraged LDI portfolios have become less leveraged — in line with regulatory guidance," said Frazer Morgan, investment consultant at Willis Towers Watson. While WTW's LDI operations "held up well during the crisis … some refinements were required," he said, such as reducing the maximum levels of leverage the firm is willing to run, and "a greater focus on medium-term liquidity — as it was not the 'LDI crisis' alone that stretched portfolios," but the combination of it with an already historic increase in yields in 2022. "This demanded more liquidity (be) accessible within weeks, rather than months. Regulatory guidance, given how well-flagged it was, refined our thinking rather than fundamentally changing it," Morgan added.
There's also been "a natural reduction in the requirement for leverage," Rae said. "As schemes are better funded, that's reduced their requirement for returns and they're looking for more cashflow-driven (allocations) — thinking about how to build that cashflow portfolio and how to make sure it provides some of the liability-hedging benefits as well."
While cash flow-driven investment has been around for some time for pension funds, there's been a "big increase in that over the course of this year," Rae said.
And some plans have taken that change in allocations as a chance to satisfy ESG requirements. "We've observed as schemes have allocated more to CDI strategies, there's a greater thought process to how that also (contributes to) sustainability — it's interesting. As leverage reduced, it's an opportunity for schemes to do more around their responsible investing agenda as well," Rae said.
There's also been a change in pooled LDI funds, in which smaller pension funds tended to be invested, which suffered in particular during the liquidity crunch. "There's been a lot of work around what is the best operational strategy for that. There's increased use of bespoke pools, so not pooling (pension funds') assets with other clients — that gives greater control over collateral movements," Rae said.
