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22 November 2022INSIGHT ARTICLE • 21 NOVEMBER 2022
What does UK gilt volatility mean for pensions governance?
Bill Manahan, Institutional Investor Lead
Originally published on FT Adviser
The recent volatility we saw in the gilt market came with a lot of noise surrounding it.
Pension schemes, specifically defined benefit, using liability-driven investment strategies faced large, immediate and in some cases multiple collateral calls.
The absorption of this cash caused stark liquidity issues for some and a complete inability to service their LDI hedges in others.
Over the past year in particular, yields have been steadily increasing, causing their price to drop. This trend was supercharged by the “mini" Budget of the Lizz Truss government. Massive long-term borrowing contained in that Budget had the effect of raising these yields even further.
This caused those leveraged LDI products to start posting large collateral requests from their owners. The irony here is that in many of these cases the capital calls were met by liquidating the very same gilts that had caused the issue in the first place, thus exacerbating the situation.
The sharpest impact was felt where hedges were not actively monitored or maintained.
What does this mean for pension scheme governance?
Strictly from a risk management point of view, these LDI strategies are not risk free and should never have been described in this manner.
Given such an important and consequential aspect of these products was glossed over (or ignored) by many of the parties involved, it became more and more likely that if/when an event, such as the one experienced, occurred, there would be mass confusion.
One area I would expect to see a rigorous review of is in the level of leverage employed by these LDI products, led by The Pensions Regulator and supported by various industry and government entities.
Some may be surprised to find that these same levels of leverage do not exist in their US counterparts.
One anecdotal reason for this dates back to Robert Maxwell and the Mirror Group Pensions scandal. In the aftermath of such a spectacular lack of oversight/governance, many, including TPR, felt it was critical to adopt methods of meeting any future obligations
LDI became the ubiquitous strategy with the level of leverage ticking up incrementally over time (as these things tend to do once found to be successful).
I would also hope to see pension schemes trying to better understand these products and the inherent risks that come with investing in them.
Rather than taking a speculative view on where rates might go over the course of the next 12-18 months, they should take a worst-case scenario approach. Truly understanding your risk profile would help make the investment decision-making process more robust.
What does this mean for pension liabilities?
In the aftermath of the "mini" Budget, there was a lot of hyperbole as to the impact this would have on pension schemes.
While those unprepared schemes faced daunting periods trying to liquidate assets to meet calls, to a large extent many schemes have found themselves in a better funding level position as a result.
Putting this into context, 29 good years versus one bad year does not necessarily represent a bad investment strategy. There are clear lessons to be learned and those who do will be stronger for it. LDI is certainly not a defunct strategy but should never have been viewed as risk-free either.
For those schemes that needed to liquidate sizeable portions of their gilts holdings to meet the calls, they may now have skewed portfolios – overweight cash and alternatives.
It will take time to rebalance their allocations. Performance may be affected as a result so perhaps it would make sense to look into alternatives to holding cash in the short term (to reduce cash drag).
Should investors worry and how can advisers help support them?
From our point of view, this crisis was made worse by the lack of genuine risk analysis and management relating to LDI strategies.
Surviving this period is not the same thing as having a robust risk-management policy (regularly reviewed) in place. I would not say investors should worry too much about their LDI strategies but would highlight the need to avoid complacency at all costs.
It is important to have healthy engagement with these strategies. An ongoing and evolving understanding of the underlying instruments and how/what potential scenarios might affect them both in the short and long term is essential.
More appropriate collateral buffers, better ongoing monitoring and maintenance linked to a more sharply focused risk profile are just some of the key steps to take.
Once these have been established, contingencies for meeting any mark to market as a result of these strategies should be designed and agreed. Does the money come from cash on hand, highly liquid holdings, and could alternative collateral be negotiated (or re-negotiated) with the appropriate counterparty?
Investors should engage their legal representative to fully scrutinise the terms of any contract and be aware of alternative terms that might work better for a fund’s specific objective.
Advisers can help in that endeavour. Greater knowledge-sharing of the risks would have eased the initial shock of this event. Forewarned is forearmed. The horse has obviously bolted in this case, but this type of mindset should be employed when viewing the entire portfolio.
In this case it was LDI strategies under the microscope, but you can bet there will be another event in the future that could have been mitigated through a deeper understanding of the risks associated with products/strategies.
One of the only things we can say with any degree of certainty is that these types of crises are happening at a faster clip.
That should make risk management increasingly central to pension scheme thinking as we face a more volatile and uncertain future.
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