Written evidence from the Hymans Robertson LDI0032
Defined Benefit pensions with liability driven investments
Introduction to our organisation
Established in 1921, Hymans Robertson helps businesses, pension funds and other financial institutions create more certain financial futures for themselves, their employees, members and customers. The majority of our business remains DB advisory and administration, but in recent years we have diversified into DC, and broader consulting to the life and financial services sector. Our roots were in advising public sector pension schemes, and we remain very strong in this sector and the wider third sector, with over 100 third sector clients now.
Background
Over the past twelve months, the UK has experienced heightened inflation triggered by strong post-pandemic demand coinciding with global supply chain constraints, pushing up prices. This has been compounded by energy and commodity price inflation (driven by the Russia-Ukraine conflict) which have pushed prices even higher.
To combat high inflation, the Bank of England has been steadily raising interest rates over the past year, with the aim of slowing demand by making borrowing more expensive. As a result, we have seen yields on nominal and inflation-linked gilts rising through the year. This had been largely well-navigated by the pensions industry as the gradual rise in yields provided adequate time for pension schemes to reposition themselves and, where required, source additional liquidity to meet capital calls from leveraged positions in their LDI exposures.
Against the backdrop of rising yields and monetary tightening, the UK Government released the proposed ‘mini’ budget on the 23 September 2022, which indicated a requirement for a significant increase in unfunded borrowing. This led to a rapid decline in the value of sterling and generated turmoil in the gilt market as investors worried about the Government’s ability to repay debt – leading to an unprecedented speed and scale of yield rises. The unexpected pace of this event placed immense pressure on asset managers to de-lever their exposure to gilts within their LDI funds and in turn UK pension schemes were forced to raise cash at short notice to meet collateral calls on these funds.
20 year Gilt Yield
Source: Bloomberg, Hymans Roberston annotation
Most schemes were able to arrange for cash to be realised from other non-LDI assets and some were able to work with their sponsors to provide liquidity. However, given the amount of collateral being called at such short notice, a number of private sector pension schemes were unable to meet the collateral call requirements to support their hedges from their LDI assets. Indeed, in some cases, LDI managers were forced to unwind hedging positions by selling gilts. There were a variety of reasons why schemes’ hedging positions were reduced, including:
1) Insufficient liquidity elsewhere in their non-LDI assets. Therefore, the only option was for them to unwind hedging to release demand for collateral i.e. rather than raising more collateral they reduced the hedging to a level that could be supported by the existing collateral.
2) Strategically it was considered an appropriate approach, in light of the scheme’s current funding position, long term direction of travel, and sponsor support.
3) Dealing restrictions on non-LDI assets meant that insufficient notice was provided to enable non-LDI assets to be sold and cash raised to meet dealing dates for collateral calls (some of which were outside of the normal dealing cycles). In some cases, it may only have been a matter of days out, but this meant cash wasn’t available to be posted in time with the LDI manager and as a result, hedge positions reduced.
The prospect, and indeed the reality in some cases, of a wave of large institutional investors becoming forced sellers of significant holdings in gilts, would create further upward pressure on yields, and in turn exacerbate the issue as more pension schemes would then be forced to unwind their LDI exposures. The net effect of this dynamic would be for supply to out-strip demand and yields to rise further still.
As this posed a material systemic market risk to UK financial stability, on 28 September 2022, the Bank of England (BoE) stepped in and announced they would temporarily suspend planned gilt sales and indicated they would purchase up to £5bn of long-dated bonds per day for ten days, to help stabilise the market and reduce yield volatility. This relieved some of the immediate pressure and helped stabilise gilt markets considerably, providing time for pension schemes and LDI managers to reposition themselves, rebalance assets and in some cases reassess what is deemed to be an optimal level, and acceptable form, of collateral.
To reiterate just how much the pace and size of gilt yield movement was unprecedented, the chart below shows all three day movements in the 20 year real yield (where the average UK pension fund has liability exposure to, and consequently where the average LDI fund is invested in).
Source: Bank of England, Hymans Robertson analysis
In summary, the speed and scale of the increase in gilt yields was unprecedented, so to expect schemes to have been entirely unaffected by this turmoil is unrealistic. The industry also saw LDI managers invoke actions that were unprecedented too, which further added to the turmoil and challenges that the pension schemes had to face.
Impact on DB schemes of the rise in gilt yields in late September and early October
UK corporate defined benefit schemes have typically fallen into three buckets as a result of the turmoil in gilt markets:
- Schemes that were well hedged and maintained their hedge. These schemes will have more than likely used up a lot of excess collateral and will be looking to replenish their collateral programme to make sure it can tolerate further volatility in the gilt market and meet the increased buffer now required.
- Schemes that were well hedged and lost some of their hedge. These schemes will have used up almost all of excess collateral and will have gone further to maintain some sort of hedge by reducing it or being forced to reduce it. The hedge reduction for most in this group will have happened at a time when yields were around their highest, so the under hedge as yields have steadied downwards will have hit funding levels.
- Schemes that were underhedged going into the crisis. These schemes will have benefited from funding level improvements as the value of their liabilities will have fallen by materially more than the asset value. They may have the opportunity now to increase hedging to protect these gains.
Since the mini budget yields have fallen (20 year gilt yield is at the time of writing 3.6% versus the high of 5.0%).
In summary, schemes that were able to maintain their hedges, will have come out of the recent situation relatively unscathed albeit with some rebalancing / restructuring which they can do at their own pace and in a controlled way. Those schemes that were forced to reduce their hedges, however, are very likely to have seen funding hits.
The exact nature of the funding impact will be very much specific to each scheme’s individual circumstances. But one thing will be universal – assets and liabilities will both be significantly smaller since the start of the year. This has many implications for funding, one being that contributions that are fixed in nature will have a larger impact in any recovery plan.
Impact on pension savers, whether in DB or defined contribution (DC) pension arrangements
For DB members, the bulk of the comments elsewhere in our response apply, but the projected pot size does not change as a direct consequence of the turmoil, but indirectly it could if funding is negatively impacted and/or if sponsors are put under pressure as result of the wider economic environment.
For DC pension arrangements, the impact was less pronounced. The rise in gilt yields will have some impact though, dependent on where members are on their journey.
Members say 15 years from retirement, who have already built up meaningful levels of savings, will be seeing significant fluctuations. This could be concerning for mid-career members who may be starting to think about their retirement, yet the current cost of living situation means they need to prioritise short-term financial needs.
Members closer to retirement, regardless of how they are invested, they will have seen falls in the value of their retirement savings over this period of stress. This will depend on which strategy they have adopted, with different implications for annuity, cash and drawdown strategies.
Appropriateness of the Pensions Regulator’s approach to regulating the use and monitoring of LDI
Clearly there is some causation between the Pensions Regulator’s emphasis on risk management, risk reduction and end game planning, and schemes adopting leveraged hedging solutions. The Pensions Regulator’s approach has primarily focused on risk management at the aggregate level rather than the specifics of LDI and the variations in approaches used by schemes.
In our view this higher-level aggregate risk management approach taken by The Pensions Regulator is an appropriate approach as it enables schemes to take a holistic approach to risk management including factoring in the scheme sponsors role and strength of covenant.
Going forward, the Pensions Regulator may look to build a deeper knowledge base on the approaches that schemes are using to manage risks including, for example collateral sufficiency in LDI mandates. However, this will be a challenge given the nuances of each scheme’s wider strategies and therefore debateable as to whether this would add value or potentially risk forcing schemes into sub-optimal investment strategies.
Adequacy of DB schemes governance arrangements
In terms of understanding the risks associated with LDI and the drivers of collateral calls etc, these were by and large well understood by the majority of pension scheme trustees. However, it was responding to those events in very short timescales that were unforeseen and unprecedented, and with exceptional LDI manager dealing constraints, that put trustees and sponsors under pressure.
For many schemes, it was the operational aspects of getting access to investments in liquid assets within the required timescales that caused as much of a problem, even those schemes that had all assets with one manager were still at risk of having their hedge unwound.
Is LDI still ‘fit for purpose’ for use by DB schemes
LDI remains an essential risk management tool for UK corporate DB pension schemes, but there will be changes to how it operates in practice going forward. We expect minimum headroom in collateral to be higher going forward and for the structure of collateral to be more granular, being split for example into collateral to be immediately available, and then a further buffer, dependent on the liquidity profile of each scheme. Establishing a large collateral buffer with a diversified, liquid, pool of supporting assets is a key priority.
Collateral waterfalls need to move from away from a volatility lens (least volatile to most volatile) to a liquidity lens (most liquid to least liquid). In the absence of funding improvements, non-LDI assets will have to target higher returns given they will make up less of the overall portfolio. A combination of liquidity and higher return seeking assets may see schemes increase their exposure to publicly listed equities. Some target hedge positions may need to be reduced as schemes balance interest rate and inflation risk with return requirements and liquidity risk.
Operationally, we expect to see clients who are able to, to move away from pooled LDI funds to more bespoke solutions where they are not in collective vehicles with other investors and forced to make collateral calls / receive payments on a generic basis with no look through to a scheme’s wider circumstances.
Essentially, solutions going forward need to allow for flexibility for scheme specific circumstances, otherwise schemes could be forced into a situation that isn’t beneficial for the scheme, the sponsor or the members.
In light of the experience, are other policy or governance changes needed
This event has brought systemic risks into focus and we are concerned about potential systemic risks of the DWP DB Funding Code draft regulations. The way they are currently proposed could well shoehorn all corporate DB schemes into similar strategies and invested very similarly. We would encourage a widening of the tram lines to allow schemes to take what might be a more suitable path for them and not all herd together in similar investment arrangements.
November 2022