Experts estimate £500bn in assets are ‘missing’ after LDI crisis

At a hearing in parliament on November 23, Leeds Business School professor Iain Clacher explained that while defined benefit funding has improved on a discounted basis, there is a gap on the assets side of schemes’ balance sheets.

He revealed that based on calculations he and Brighton Rock Group head of research Con Keating have made, there is an estimated £500bn “probably missing somewhere”.

“This is not a paper loss, this is a real loss, because pension funds were selling assets to meet their collateral calls,” he said.

This is not a paper loss, this is a real loss, because pension funds were selling assets to meet their collateral calls

Iain Clacher, Leeds Business School

“What we’ve actually seen is a significant reduction in the overall pot of assets that are available to pension funds to pay pensions in the fullness of time.”

The Work and Pensions Committee launched an inquiry into the regulation and governance of DB schemes with LDI in October, after the introduction of the Bank of England’s emergency £65bn bond-buying programme earlier that month.

This intervention followed the so-called “mini” Budget on September 23, which saw falling government bond prices prompt a series of collateral calls from DB schemes that some feared would lead to a “doom loop” that would crash the market. 

Issues arose specifically around pension funds’ LDI strategies, designed to protect against falling interest rates. Most schemes had conducted stress tests for a scenario in which there was a 1 per cent rise in long-term gilt yields, but the 4 per cent rise exceeded the contingency plans of several, prompting the BoE’s intervention.

There has been some dispute as to the true severity of the crisis. Several industry experts were quick to reject the suggestion that there could be a widespread collapse of pension funds, and the Pensions Regulator — which some felt should have been more proactive in addressing LDI and its role in the crisis — suggested that most schemes had “sensible waterfall measures in place” to face collateral calls.

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.

Leverage was the cause of the crisis

The MPs heard from a group of experts who believe leveraged LDI was the main cause of this crisis, with some calling for this feature to be banned.

It is common for schemes to introduce leverage into their LDI portfolios to free up capital to invest in growth assets, and in the case of an interest rates rise — where liabilities and asset values fall — this leverage will increase.

As a result, the LDI fund manager will require additional capital to reduce the leverage to the original level.

Independent consultant John Ralfe explained that there is a difference between “matching your assets and liabilities, which is hedging, and leveraged LDI, which is pure speculation”.

He argued that the “big incentive for companies to do leveraged LDI is that it allows them to match the liabilities on the balance sheet”, giving the example of BT, which sponsors one of the biggest DB schemes in the UK market and has “matched 95 per cent of their interest rate and inflation exposure”.

At the same time, they “can still invest lots of these fantastic assets”, such as private equity, quoted equities, property and hedge funds, he said. “The advantage for the company of doing that is that they can reduce the deficit contributions,” he added.

Keating commented: “If you are in deficit and you are trying to hedge, your assets need to be riskier than your liabilities in order to achieve matching.

“If you then add to that the objective of make good deficit, you are adding yet another layer of risk to your asset portfolios, which is why I don’t think LDI makes sense.”

Leverage is already being reduced

The committee heard contrasting views on leverage from industry practitioners, who still believe it is appropriate for schemes and detailed steps that are being put in place to reduce risks.

LCP partner Jonathan Camfield disclosed that investment managers, working alongside the Financial Conduct Authority and the BoE, “have reduced leverage within pension schemes”, and “there is now more cash — collateral — available within LDI than there has been for many schemes before, so that risk is already being reduced”.

However, he noted “there is a risk that without further guidance from regulators or potentially rules […] competitive pressures over time just put leverage back to where it was”.

He added: “Leverage is a very efficient and useful thing to use. Some strong guidance from the regulators requiring that investment managers have line of sight to amounts of cash or other collateral that would give protection against further rises in interest rates would be helpful.”

 Leah Evans, pensions board chair at the Institute and Faculty of Actuaries, detailed that the amount of collateral managers now hold for a typical scheme has increased.

“It was aimed at withstanding an immediate increase in yields of 150 to 250 basis points, it is now more like 350bp to 450bp, so that means if we saw a repeat of the spike in yields it would have to be far more extreme before we have the same sort of reaction,” she said.

She also explained that pooled funds, which had issues in getting additional collateral quickly due to having many investors, are now requiring pension schemes to “have additional assets invested with the same manager — say corporate bond funds — that they can directly draw collateral from”.

Evans disagreed that leverage is bad for pension schemes. “It is more about the level of leverage that is used: higher levels clearly introduce more risks, but also how the LDI portfolio fits into the wider strategy of a pension scheme,” she said.

“The schemes that struggled were the ones that had less liquid assets in the rest of their portfolio, and I wouldn't necessarily recommend knee-jerk reactions on banning levels of leverage. More guidance around leverage could be helpful, more data collection certainly, but I think the problems are more scheme specific and not just driven by leverage as such.”

More data needed

Camfield echoed the need for more systemic risk data, which is not currently held by TPR.

He noted that the watchdog has the means to collect the data through the schemes’ annual returns, and this information should be gathered to have a “sight to all schemes”.

TPR should then share this data with the FCA and the BoE, and “further analysis should be done about the level of systemic risks and shared appropriately with pension schemes, us, the market, so that individual pension schemes can adjust their decisions based on the level of systemic risk from time to time,” he said.

“To me, that was a regulatory gap as we came into September,” he added.