Written evidence from the Insight Investment LDI0029
Executive summary
Insight Investment is one of the UK’s largest investment managers, managing £683bn in assets for pension schemes, insurers, sovereign wealth funds and financial institutions[1]. The majority of Insight’s assets under management are in risk management solutions (primarily liability-driven investment, or LDI) and fixed income.
Insight Investment has actively engaged with policymakers in matters relating to LDI for over a decade and we are keen to engage with policymakers on the recent market turmoil, its impact on pension schemes, and lessons learned from it.
We are grateful for the Work and Pensions Committee for its focus on these issues and we are pleased to share our experience and views on LDI for defined benefit (DB) pension schemes. In this document we provide some background on LDI and then provide our answers to the questions from the call for evidence.
Key themes we would like to highlight include:
• Linking the valuations of assets and liabilities to help secure benefits for DB pension scheme members, including through the use of LDI strategies, is prudent and appropriate. Asset/liability matching remains as relevant and helpful as ever in achieving long-term stability in pension portfolios. Thanks to the use of LDI, UK pension schemes are typically in a much better position today, with improved funding levels and with far fewer schemes in deficit. The recent experience does not change this assessment, though it highlighted the need for LDI strategies to become more resilient in the face of unexpected volatility and liquidity challenges.
• The speed of the rise in yields during late September and October was unprecedented, and liquidity conditions were challenging. There were typically two main implications for UK DB pension schemes: a reduction in the present value of liabilities and the need to sell assets to support unfunded (leveraged) exposure. With regard to the latter, the recent events stemmed from a mismatch between the liquidity of pension schemes’ assets and the margin requirements of their LDI portfolios. This was a liquidity, not a solvency, challenge for pension schemes.
• The overall impact on pension savers in DB pension schemes has been limited, in our view. DB pension schemes remained solvent throughout these events. Some pension schemes would have faced adverse consequences due to the partial liquidation of portfolios and/or reductions in hedge sizes but, overall, the present value of pension schemes’ liabilities has declined to a greater extent than the value of their assets, and we believe the overall health of the pension industry has improved.
• The Pensions Regulator (TPR) has supported prudent risk management to secure members’ benefits, including through LDI. We support the regulator’s approach, and believe it is no coincidence that countries adopting a liability-focused approach (the UK and Netherlands) have among the healthiest DB plans in the world.
• DB pension scheme trustees are typically required to seek professional advice when making investment decisions, including with regard to LDI strategies.
– a review of liquidity, as the rise in yields means that illiquid allocations form a greater proportion of the assets of a typical pension scheme
– a more integrated approach, with trustees providing LDI managers with greater access to non-LDI holdings, enabling greater oversight of pension schemes’ collateral resilience and to help ensure that assets can be sold in a more timely and efficient manner when needed
– governance enhancements, with pension scheme trustees considering whether governance enhancements could support faster decision-making in future; governance stress tests could help assess this
– greater visibility for regulators of pension schemes’ collateral buffers, to help them identify the most vulnerable schemes
– regulation to incorporate greater support for non-cash collateral for relevant transactions
– a greater focus by policymakers on the stability and liquidity of the gilt market; the dysfunction in the gilt market was unprecedented and created adverse consequences beyond those experienced by pension schemes
Background
What is LDI, and why is it so prevalent in the UK?
Defined benefit pension schemes have promised to provide a retirement income to their members. To achieve this, schemes need to ensure that they have sufficient assets to cover these liabilities over the life of the scheme. The basic measure of a pension scheme’s ability to meet its commitments is its funding level, which measures how much of its total liabilities are covered by its assets.
Historically, pension schemes were underfunded, meaning they did not have enough assets to cover their liabilities. Because the value of future pension payments is directly linked to inflation, interest rates and the longevity of a pension scheme’s members, trustees have sought investments that are linked to such factors. If the value of scheme assets and liabilities react to these factors in the same way, the liability risks are ‘hedged’, and funding level volatility can be greatly reduced – providing a solid foundation on which to invest for growth to close any deficit. This stability has been very beneficial for pension schemes, their members and their corporate sponsors.
The focus of UK pension schemes, corporate sponsors and regulators on the funding level of pension schemes, and their plans to achieve full funding (meaning they can fulfil their promise to members), has led most schemes to use LDI strategies. By investing a portion of assets to help manage liability risks and using remaining assets for growth, LDI has offered a much smoother path to improved funding without compromising on target returns. We believe that due to the use of LDI, UK pension schemes are in a much better position today, with greatly improved funding levels and with far fewer schemes in deficit.
How do pension schemes use LDI in practice?
In general, for a fully funded pension scheme, the ideal holding is an index-linked gilt as these instruments provide a close match to the present value of pension scheme liabilities. However, pension schemes that are not fully funded and seeking to improve their funding position need to invest in assets that deliver a higher return.
Pension schemes therefore acquire unfunded exposure to index-linked gilts (i.e., using leverage) to access the liability-hedging characteristics they require. The use of leverage releases capital to acquire a portfolio of other investments that pay a premium over gilts, such as equities, corporate bonds and other assets.
LDI portfolios can be implemented with no leverage or with some leverage, with the leverage level varying depending on a pension scheme’s circumstances over time. Importantly, a pension scheme’s ‘journey plan’ often involves the reduction of leverage as its funding position improves.
In the case of LDI portfolios using leverage, a certain portion of a schemes’ assets would be allocated to LDI portfolios as collateral so that they can meet margin calls (when a counterparty requests collateral to cover a fall in the value of the unfunded liability-hedging exposure). As margin calls deplete collateral allocated to the LDI portfolios, then the pension scheme releases further capital from elsewhere in its overall portfolio to replenish the collateral buffer. In order to prudently manage risks introduced by the use of leverage, collateral buffers are typically strictly monitored to ensure that sufficient liquidity remains based on historical stress tests.
It is important to note that while the collateral buffer in the LDI portfolio is usually less than the size of the overall hedge, creating a leveraged position, pension schemes are typically not leveraged taking into account a scheme’s total assets, including those outside its LDI portfolio that are part of its ‘journey plan’ described above.
Historically, without using leverage in an LDI portfolio, the burden of plugging a funding gap for less well funded schemes would have shifted to their corporate sponsors – meaning sponsor contributions would likely need to increase substantially, leading ultimately to negative implications for the UK economy. Additionally, without leverage, pension schemes’ ability to invest in the wider economy, including through gilts, corporate bonds and equities, would be curtailed, also potentially leading to further negative outcomes for the UK.
It must be noted that the calibration of leverage, and strategies to sell assets to reduce leverage, were rooted in the previous regime of gilt market stability and liquidity. These are now being revisited to adjust them for the possibility of a more volatile and less liquid gilt market going forward.
Call for evidence: questions and answers
Q1. The impact on DB schemes of the rise in gilt yields in late September and early October
The speed of the rise in yields during late September and October was unprecedented, and liquidity conditions were challenging. After the announcement of the mini-budget on 23 September, the 30-year index-linked gilt yield increased 2.3%[2], including intra-day moves, within four business days. This compares with an average daily move over the last decade of c.0.03%[3], and a move of c.0.96% within eight business days over the March 2020 COVID crisis[4].
The Deputy Governor of the Bank of England, Sir Jon Cunliffe, noted that: “the scale and speed of repricing leading up to Wednesday 28 September far exceeded historical moves, and therefore exceeded price moves that are likely to have been part of risk management practices or regulatory stress tests.”[5]
The rapid increase in gilt yields typically impacted UK DB pension schemes in two main ways:
• an initial reduction in the present value of liabilities (as a result of higher gilt yields) that was larger than the fall in asset value, as most pension schemes do not fully hedge their liability risks; and
• the need to support unfunded (leveraged) exposures increased rapidly and necessitated sales of assets, which in turn created further market pressure.
Figure 1: Liability valuations fell by more than asset valuations through the recent events…6 |
| Figure 2: …leaving pension schemes in a better overall funding position in the immediate term[6] |
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The recent events stemmed from a mismatch between the liquidity of pension schemes’ assets and the margin requirements of their LDI portfolios. Disposing of assets may take days or weeks for less liquid assets. In contrast, margin requirements on LDI portfolios are typically settled daily and mostly in cash. This presented challenges for pension schemes’ liquidity, not solvency.
Various factors exacerbated the recent events:
• Real yields had been rising steadily through 2022 (amounting to a rise of circa 2.5%[7] – see Figure 3), reversing fifteen years of rate reduction. As a result, pension schemes had already adjusted their portfolios to release capital from their other liquid assets, meaning schemes had fewer liquid assets to sell entering the period.
• We estimate that pension schemes and insurers hold circa 90% of the UK long-dated index-linked gilts in issuance, according to Insight estimates. As pension schemes sold these assets, there was not another natural buyer in material size, meaning prices fell rapidly.
• As observed above, there may have been cases where LDI portfolios had to sell gilts to reduce the risk of continued collateral pressures, especially in the case of pooled funds, which have pre-defined leverage management mechanisms.
• Collateral provided to support LDI portfolios is typically required in cash or gilts, meaning other assets would need to be sold to raise enough collateral. This is partially a side effect of regulations intended to bolster banks after the financial crisis.
Figure 3: Fifteen years of real yields reversed in nine months (% yield on 2055 index-linked gilt)[8] |
| Figure 4: Real yields spiked dramatically (% yield on 2055 index-linked gilt)5 |
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Q2. The impact on pension savers, whether in DB or defined contribution pension arrangements;
The impact on pension savers in DB pension schemes would have been limited, in our view. As mentioned in our answer to Question 1, DB pension schemes remained solvent throughout these events.
We offer some observations on DB schemes and their members:
• We are not aware of any DB pension schemes entering into contractual default on their margin obligations with banks during these events.
• A DB pension scheme’s sponsor would typically be required to meet any shortfall in meeting members’ pension promises, even if funding levels deteriorated, so the impact to pension savers should be minimal.
• Any DB pension scheme that reduced its liability hedge by selling gilts during the market turmoil, and then increased its hedge by purchasing gilts after the market recovered, would have experienced an adverse impact on its funding level (all other things being equal).
• Any DB pension scheme that was a forced seller of return-seeking assets at unattractive levels would have seen a reduction in the value of their asset portfolios, and experienced an adverse impact on its funding level (all other things being equal).
• Any pension saver that transferred out of a DB pension scheme during the period of market dislocation could have received a lower transfer value than if they transferred before or after the recent events.
However, pension savers investing via DC pension schemes in gilts (e.g. DC lifestyle arrangements in later stages), or in other financial markets, would likely have seen a reduction in the value of their investments as asset markets fell overall during this period, but this decline would have since partially reversed.
Q3: Given its responsibility for regulating workplace pensions, whether the Pensions Regulator has taken the right approach to regulating the use of LDI and had the right monitoring arrangements;
In supporting prudent risk management to secure members’ benefits, including through the use of LDI, The Pensions Regulator (TPR) has helped create an environment in which the solvency of UK DB pension schemes has greatly improved. We believe it is no coincidence that countries adopting a liability-focused approach (the UK and Netherlands) have among the healthiest DB plans in the world.
Considering that the recent events were driven by a mismatch between the liquidity of pension schemes’ assets and the margin requirements of their LDI portfolios, we note that liquidity risk has been clearly highlighted by TPR to trustees in the adoption of LDI. For example:
• In 2019, a TPR survey assessed leverage and liquidity within DB pension schemes “to assess the potential for systemic risks to arise due to the use of leverage in DB pension schemes”.[9]
• TPR’s Annual Funding Statement 2022 repeatedly highlights liquidity risk, and specifically states that trustees “should also consider short-term liquidity needs in the pension scheme and how these may be affected by margin calls”.[10]
In line with a prudent focus on liquidity risk, pension schemes had already been working to replenish their collateral pools in light of rising yields through 2022. However, the speed of the rise in yields during late September and October was unprecedented, and exceeded yield moves likely to have been part of risk management practices or regulatory stress tests (see our answer to Question 1).
We note that the European Central Bank (ECB) published findings in May 2020 of its analysis of the potential impact of margin calls on Dutch pension schemes adopting LDI strategies. The ECB applied stress tests of a 1% rise in rates,[11] which is similar to typical stress tests previously applied by UK DB pension schemes. The moves in gilt yields in September and October far exceeded such levels (see our answer to Question 1), once again highlighting that regulatory stress tests would not have helped to prepare adequately for the recent market moves.
Q4: Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?
DB pension scheme trustees are typically required to seek professional advice when making investment decisions, including with regard to LDI strategies.
In terms of governance, the overwhelming majority of our clients were able to convene ad-hoc meetings at short notice, enabling swift decisions to sell assets to source collateral for their LDI portfolio, but this was more challenging for a small minority of schemes.
Overall, we believe that some pension schemes may wish to consider whether governance enhancements could support faster decision-making in future; governance stress tests could help assess this. These could take the form of trustees replicating recent events to assess whether their operational and governance processes enable timely and effective decisions.
Q5: Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?
We believe the fundamental principle underlying LDI – investing a portion of assets to help manage liability risks and using remaining assets for growth – remains as relevant as ever.
Even accounting for recent events, LDI has substantially reduced the volatility of schemes’ funding statuses, improving the certainty of meeting pension promises (see our answer to Question 1). However, the recent events have highlighted ways for LDI strategies to become more resilient in the face of unexpected volatility and liquidity challenges.
We would highlight the need for the following:
• an overall reduction in LDI portfolio leverage; following recent events, the leverage across LDI portfolios has been reduced and we expect this to continue. Reduced leverage should help LDI portfolios to withstand larger rises in yields, and with improved overall funding levels over the year so far, the need to use leverage to invest for growth has declined. However, some leverage remains necessary for schemes in deficit to avoid the burden of plugging the funding gap for schemes shifting to sponsor corporates.
• a review of liquidity; the rise in yields leading to falling asset and liability values, combined with liquid assets being sold to meet margin calls over the year, has meant that pension schemes' illiquid allocations as a proportion of their overall portfolio may have increased – perhaps even doubled in some cases. These may need to be rebalanced, and in assessing the appropriate level of liquid assets needed, pension schemes may wish to apply more stringent stress tests.
• a more integrated approach, with trustees providing LDI managers with greater access to non-LDI holdings, enabling greater oversight of pension schemes’ collateral resilience, and to help ensure that assets can be sold in a more timely and efficient manner.
We would also note that there is likely to be greater demand from DB pension schemes to be able to post a broader set of assets as margin for their LDI portfolios (such as corporate bonds). As such, we believe it would be helpful for banking regulation to support the acceptance of a broader set of collateral for certain contracts. See also our response to Question 6 on a related point.
Q6: Does the experience suggest other policy or governance changes needed, for example to DB funding rules?
The recent experience has highlighted some improvements that could be made, taking into account that the gilt market can become dysfunctional. Enhancements we would identify include the following:
• greater visibility for regulators of pension schemes' collateral buffers, to help regulators identify the most vulnerable schemes.
• regulation to incorporate greater support for non-cash collateral to support margin calls for both repo and derivative transactions may benefit pension schemes more broadly.
On the latter point, we recommend that UK’s on-shored European Market Infrastructure Regulation (EMIR) rules and associated bank capital rules make permanent the clearing and credit valuation adjustment[12] exemptions provided to pension schemes for derivative transactions so that they are not forced to post cash as variation margin, which is the case for pension schemes using central clearing.
We also recommend that certain bank capital rules (e.g., leverage ratio rules for non-cleared derivatives) that currently do not recognise any non-cash variation margin that is posted, even gilts, be reconsidered. This is because these rules reduce banks’ appetite for accepting non-cash margin, thereby putting undue pressure on pension schemes to post margin in cash format only for non-cleared transactions.
• a greater focus by policymakers on the stability and liquidity of the gilt market; the dysfunction in the gilt markets was unprecedented and created adverse consequences beyond those experienced by pension schemes.
November 2022