DB schemes and LDI: ‘We’re through that firefighting phase’

Chaos ensued after the former government’s doomed ‘mini’ Budget, which pledged extensive unfunded tax cuts. Markets deteriorated, gilt yields spiked and collateral calls poured in, forcing trustees and their advisers to work around the clock. Assets, including gilts, multi-asset credit and equities, were sold down in a scramble for liquidity. 

Reporting by some sections of the media – that the very solvency of schemes was under threat – have since been dismissed by the industry and regulators.

The Bank of England nevertheless felt it necessary to launch a £65bn gilt-purchasing programme aimed at stabilising prices. The BoE later claimed that some liability-driven investments would have been rendered worthless without its intervention.

There have been fiduciary managers that I don’t think have managed to get through this crisis particularly well

Natalie Winterfrost, Law Debenture

Schemes were in contact with the Pensions Regulator, which sent them a fact-finding survey and urged them to review their liquidity, liability hedging and governance.

The ‘mini’ Budget has now largely been abandoned. 

Markets welcomed the arrival of Rishi Sunak to Number 10 and the retention of Jeremy Hunt as chancellor of the exchequer. The yield on 30-year gilts, which smashed through 5 per cent at the height of the market turmoil, sat at around 3.75 per cent on October 26.

Schemes are likely better prepared for another shock, if and when the honeymoon ends. LDI funds would now be ready to answer sharper spikes in yields, the BoE has said.

The disruption has raised questions over the future of LDI. It has also prompted an inward look at scheme governance and investment strategy. 

On October 25, a host of professional trustees and advisers gathered at Invesco’s London office to offer their thoughts on LDI and governance, debating how both will evolve to meet the challenges facing schemes.

‘We did not expect such demands on liquidity’

During the crisis, LDI fund managers told Pensions Expert’s sister title MandateWire that they were likely to reduce the levels of leverage used in their funds.

“Clearly we did not expect such demands on liquidity,” Law Debenture director Natalie Winterfrost said. 

“It does mean that you have to re-evaluate, for example, how your equities are invested. [It’s] not very helpful if the fund that they’re in only trades weekly, for example. You think of equity as a very liquid asset class.”

While the spike in gilt yields that followed the ‘mini’ Budget was problematic for some schemes, others jumped at the opportunity to reap the rewards of shrinking liabilities, which improved their funding positions. 

Some schemes approached their sponsoring employers for advances on contributions, in order to preserve their hedging ratios and lock in these stronger funding levels. Pensions Expert is aware of at least one scheme that was approached by its own sponsor with a view to doing the same.

Schemes have nevertheless been through a frenzied period that has also been difficult for LDI advocates, who are now left to defend and make the case for the concept.

“We’re through that firefighting phase now,” XPS Pensions Group chief investment officer Simeon Willis noted. “We’re not in the same place we were a month ago.”

“The concept of LDI, I think, is as relevant today as it ever was. But it’s more difficult to implement in light of what we’ve learned.

“We know we need to run lower levels of leverage. We need to have greater access to forms of liquidity that can top up our cash buffers when they get depleted,” he said.

Winterfrost cautioned that the volatility and the crisis that ensued could happen again, suggesting that the way valuations are carried out should also come under review.

“Diversification is key,” she said. “We know that pension funds are the dominant investor in UK sterling bond markets, and when they’re all acting together, that causes a problem.”

“We have to question whether the way we’re doing valuations is right,” she continued. “I’m not predetermining the answer to that, but we’re pricing off gilts, and that causes us to herd into gilts and gilt-like assets.”

Fiduciary managers were hard to track

Fiduciary management offers trustees a combination of investment advice and the outsourcing of the management of their schemes. Proponents of the practice point to the smoother running of a scheme that frees up trustees’ time to concentrate on strategy.

Ross Trustees trustee director Roger Mattingly raised the upside and downside of the fiduciary model during the turbulence.

“On the one hand, fiduciary was useful because of the spontaneity,” he said. “But trying to keep track on what fiduciary managers were actually doing was quite challenging.”

Mattingly recalled receiving three collateral calls in half an hour, worth “many millions”.

“You end up deciding, psychologically, these are tactical decisions – not strategic decisions,” he said.

The period involved “finding the money and then making active decisions”, he said. “Do we make all the collateral calls? Do we keep the hedge in place, or not, and if we don’t, why wouldn’t we?”

“There was one scheme where we had significant contingent charges over some very nice, desirable West End properties,” he added, “which actually is comfortably greater than the buyout deficit, and we had some buy-ins as well, which were obviously fully hedged.”

“On that one, we actually didn’t meet the collateral calls,” Mattingly said, adding that the scheme subsequently “bought some gilts”. 

Winterfrost stressed the importance of governance and accepted that fiduciary management could be helpful in cases where schemes lack governance budget. “But I don’t think it’s a panacea,” she said.

“There have been fiduciary managers that I don’t think have managed to get through this crisis particularly well, that have been slow to communicate with trustees that they lost the hedge, and the justification for being slow to communicate that to trustees was that it took them a while to find out.”

“There are boards that I sit on that were getting collateral position updates and hedge updates by the day, and had a small subset of the trustees that had been agreed to be looking at this.

“While the speed of that week… was a shock, actually, collateral as a challenge had been going on all year. We had seen rising rates, and we had been moving out of positions of comfortable levels of collateral, to frequently having to top up our collateral.”

Independent trustee Ian Maybury said that “multi-manager” fiduciary management “has probably struggled more” than single-manager fiduciary management.

Trustees defend TPR’s role

TPR was criticised by some pundits over its perceived inaction during the crisis. The watchdog did, however, issue guidance to DB and defined contribution schemes, and also disclosed that it had approached the BoE and other regulators over actions they could take in response to the volatility in the gilt markets, before the central bank intervened.

“On some of my schemes we proactively updated the regulator to let them know that the platform was causing a strain, and what we were doing about it,” Winterfrost said.

“We didn’t get many questions from the regulator until they, themselves, had to respond, where we were asked to fill out a survey.

“I think the regulator has been supportive of the LDI strategies, and that has been helpful.”

Three of Maybury’s schemes were contacted by the regulator – one that is part way through one-to-one supervision, and two that are midway through valuation processes.

“All they really were doing was information-gathering,” he said. “They didn’t offer an opinion. They did want to know a little bit about what we were doing, but it wasn’t very intrusive.”

Mattingly suggested that in the absence of any “blanket solution, it was very difficult for the regulator to intervene”.