Written evidence from the Columbia Threadneedle Investments LDI0033
Columbia Threadneedle Investments Response to the House of Commons Work and Pensions Select Committee Call for Evidence
We, Columbia Threadneedle Investments (“Columbia Threadneedle”), write in response to the inquiry from the Work and Pensions Select Committee of the UK Parliament. The inquiry seeks input about the lessons to be learned from the recent increase in gilt yields that caused defined benefit (DB) pension schemes using liability-driven investment (LDI) strategies to deal with the rapid increase in collateral requirements.
While we have contributed to one of our trade group’s forthcoming written comments, we are submitting this separate comment letter focused on a small set of issues that we believe are important considerations for the ongoing effective management of LDI portfolios.
Columbia Threadneedle is a leading provider of LDI solutions, having run LDI portfolios for defined benefit pension scheme clients since 2003. As at end June 2022 we had £110bn of liabilities under management across over 600 client mandates, spanning both sterling and euro denominated pension schemes. Around 67% of our managed liabilities are for UK schemes, with the remainder representing Dutch, German, and Irish schemes. We offer the full range of liability matching solutions including buy and maintain, passive and value-add systematic strategies. Our clients access our LDI services through pooled funds (directly and via investment platforms), segregated portfolios, and funds of one. We also have experience with a range of governance models with some clients holding internally managed collateral waterfalls and others externally managed collateral assets. We run LDI mandates for third party fiduciary managers as well as for our own internal fiduciary management teams operating in the UK and the Netherlands.
We note that our pension scheme clients will take advice (and are legally required to do so in respect of investments (s.36 of the Pensions Act 1995)) from experienced investment consultants. In our experience working with pension scheme clients, we have observed that such investment consultants typically have specialist LDI teams, and we have been subjected to research and due diligence before being recommended as an LDI manager.
As has been widely reported, the recent sharp rise in gilt yields resulted in a fall in the value of pension scheme liabilities, causing a fall in the value of liability matching for LDI portfolios that required them to post collateral/margin in respect of hedging positions. This needed to be done quickly, and where this could not be done it was necessary to reduce exposure by closing out liability hedging positions. The challenge on this occasion was not just the severity of the market moves but the speed with which they occurred. For context, the fall in the value of the 30-year UK index-linked bond was over 50% in 8 days in September. This compares to the S&P falling 46% over 18 months during the Global Financial Crisis.
Nonetheless, we do believe there are valuable lessons to be learnt from the recent experience, and we encourage LDI participants, including trustees and advisers to DB schemes, to assess their existing arrangements and consider whether additional flexibility may be afforded to more effectively position DB schemes to deal with such extreme market events should they ever reoccur. With this in mind, we offer the following suggestions.
Consider Holding Additional Collateral Buffers with the LDI Manager and Expanded Delegation
In our experience, clients with the best outcomes over the last few months were those holding other liquid assets with us as their LDI manager, often referred to as a collateral waterfall. This ready and more immediate access to these liquid assets allowed us to rebalance directly between these liquid assets and LDI automatically, where the need arose. The benefits are speed of rebalancing and a reduction in governance and risk for the trustees. Therefore, investors should consider holding additional liquid assets with their LDI manager and granting the LDI manager discretion to rebalance leverage automatically from these assets.
Scrutinize the Composition of Assets Held as Collateral Waterfall
In constructing a collateral waterfall, we encourage trustees and advisers to apply more scrutiny to assets that appear liquid in benign market conditions but whose liquidity deteriorates in a crisis, for example Asset Backed Securities. Investors should therefore focus on daily dealt funds with short settlement cycles and proved underlying liquidity when constructing collateral waterfalls.
Consider Use of Corporate Bonds as Collateral
There are benefits for DB pension funds (similar to insurers) from using the corporate bonds that they hold as collateral for non-cleared swaps. The market should therefore explore the feasibility and cost of expanding collateral terms in some instances.
We are mindful that market events can sometimes precipitate instinctive reactions that could in the long term cause more harm than good. For example, as to the DB funding code, whilst there have been calls to move away from using a market derived interest rate for valuing liabilities, the need to have something that is both measurable and investable leads us in our view towards retaining market derived interest rates as the basis of a prudent funding code. We would caution against a return to a model where schemes can set fixed discount rates based on assumed future asset returns. This would be likely to introduce a high degree of subjectivity and variation between schemes, whilst also resulting in a significant backwards step on the journey to low dependency on the corporate sponsor.
Columbia Threadneedle appreciates the opportunity to respond to the Committee’s inquiry. We look forward to continuing to work with the Committee and other market participants on these important issues, and we commend the Committee on its diligent efforts to assess recent market events.
November 2022