‘Lower leverage is here to stay’: industry responds to LDI inquiry

The select committee opened its inquiry into LDI on October 24, following a turbulent month for schemes that saw many face collateral calls from LDI managers in response to a spike in gilt yields. Yields jumped after the government announced its mini "Budget" at the end of September.

The committee has received oral evidence from experts and is also receiving written submissions from across the pensions industry. The Pensions Regulator, the Pension Protection fund, consultants, trustee companies and trade bodies are among those to have written to the MPs.

The inquiry asked respondents whether TPR had taken the right approach to regulating LDI, whether defined benefit schemes had sufficient understanding of the risks involved and whether policy changes are required in response to the crisis.

I advised the Adnams trustees to avoid LDI, which they did

Stephen Pugh, Adnams Pension Scheme

While not a unanimous view, a number of respondents have called for changes to LDI regulation. 

TPR’s conduct in response to the volatility has largely been backed, although there is a consensus that the regulator has encouraged schemes’ use of LDI.

Could lessons on leverage be learned from the insurance industry?

LDI funds are typically domiciled in the Republic of Ireland and Luxembourg. On November 30, the Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier — known together as the national competent authorities — noted an improvement in the resilience of sterling-denominated LDI funds across Europe, with an average yield buffer of around 300 to 400 basis points having been secured. 

This buffer refers to the level of yield adjustment on long-term gilts that an LDI fund is insulated from, or may absorb, before its capital reserves are depleted.

Before the fiscal statement, 48 per cent of schemes had capital buffers below 200 to 249bp, according to the Pensions and Lifetime Savings Association’s submission to the Work and Pensions Committee. 

Just one in five schemes had buffers of more than 300bp. In early October, more than half said they planned to increase their collateral buffer to more than 300bp by October 14, while a tenth intended to make their buffer 250bp.

In the six to nine months leading up to the fiscal statement, the average daily move in gilt yields may typically have been 2-3bp, the PPF said in its own submission. 

The previous biggest recorded increase in a day was 29bp. In the four trading days leading up to the Bank of England’s gilt-buying intervention, there were two daily increases in excess of 50bp, while across the four-day period the total increase in yields was around 153bp. 

“The speed and magnitude of the yield increases were truly exceptional, surpassing anything experienced in other financial crises in recent memory,” the PPF said.

The PPF suggested that consideration could be given to appropriate levels of LDI leverage. 

“Schemes running leveraged LDI strategies should have sufficient liquidity to cover appropriate stress scenarios,” it said. 

“There could also be lessons to be drawn from the insurance industry (from where the LDI concept has its origins) where there are commonly higher capital requirements and tighter rules on borrowing.”

Former Columbia Threadneedle global head of asset allocation Toby Nangle told the committee that it was “not uncommon” for schemes “to run cushions of 100-150bps to exhaustion”.

This represents the amount that long-dated bond yields can increase before excess collateral is exhausted in margin calls and needs to be replenished.

“My expectation, and the expectation of those in the industry, is that lower leverage is here to stay,” he said.

TPR ‘encouraged’ schemes to use LDI

TPR’s role in the adoption of LDI by schemes has come under scrutiny and is part of the Work and Pensions Committee’s inquiry. Among submissions there was a clear consensus that the regulator has encouraged the adoption of these strategies.

The watchdog “has generally welcomed the use of LDI strategies to hedge risks and has rightly encouraged trustees to monitor risks to their schemes using an ‘integrated risk management’ framework,” the Institute and Faculty of Actuaries wrote.

“TPR has undoubtedly encouraged schemes to adopt LDI strategies,” Barnett Waddingham said. “This is a good thing in our view.”

TPR told the committee in its written submission that “hedging tools such as LDI can be an appropriate way to mitigate risk for DB pension schemes and their sponsoring employers,” noting that it had been used “effectively” for around two decades.

Barnett Waddingham added that the PPF “has also indirectly encouraged schemes to adopt LDI strategies”. The PPF is funded by a levy paid by eligible DB schemes.

“For most schemes, adopting an LDI strategy will result in a lower levy, precisely because it does reduce the chance that the scheme solvency position deteriorates and the scheme subsequently enters the PPF,” the consultancy commented.

Dalriada Trustees said that it “would encourage the committee to recommend to government to ensure stronger regulatory oversight of LDI products, with strong arguments for collateral stress tests to be applied at a product level”. 

“We recognise the challenges in doing this where many products are based outside the UK,” it admitted.

The events of the autumn may have implications for new DB funding rules, with TPR's new code expected in September 2023. 

The new DB funding code proposes a twin-track approach to valuations, under which schemes will be able to choose between a bespoke route or a more prescriptive fast-track option. 

The Railways Pension Trustee Company, which is the corporate trustee of the UK’s main railway schemes, warned that the new rules “could exacerbate systemic risks to the UK economy due to pension scheme ‘herding’”, given their prescriptive nature.

“Whilst LDI with a controlled and low level of leverage can be an effective risk-management tool for some schemes, the use of synthetic assets with excessive leverage is likely to make the impact of ‘herding’ worse,” it said.

‘I advised the trustees to avoid LDI’

Some contributors were keen to emphasise the importance of making leverage within LDI available to schemes.

BT Pension Scheme Management, which oversees the BT Pension Scheme, told the committee it had increased its hedge ratios for interest rates and inflation to around 70 per cent this year from around 20 per cent on a solvency basis in 2012.

It has had a long-term objective to hedge at least 60 per cent of its interest rate and inflation risk — on a Solvency-type basis — or around 90 per cent on a technical provisions basis. This goal was achieved last year.

“The implementation of the interest rates hedging programme has been key in managing the volatility of the scheme’s funding position and has proved very effective,” it said.

The scheme’s last triennial valuation in 2020 yielded a funding deficit of £8bn. The scheme manager estimated that without the LDI hedging programme, the deficit would have been £7.6bn higher, or at least £15bn, which would have required BT “to pay significant additional contributions to repair the deficit”.

Consultancy Cardano, meanwhile, told the committee: “Without the use of leverage within the LDI strategy, there are schemes where the level of sponsor contributions required would be such to impact the sponsoring [company's] operating business or be too great for the sponsoring company thus compelling the scheme to the PPF.”

But Stephen Pugh, an adviser to the trustees of the Adnams pension scheme, cited an estimate in the Financial Times that around £1.6tn of pension liabilities are linked to inflation, while the total index-linked gilt market is worth around £800bn.

“I was unclear who, in these circumstances, would ultimately meet the inflation risk as it seemed that if inflation-linked assets were in short supply to pension schemes then they would be in short supply for everyone, including those standing behind the derivatives,” he told the committee. 

“No one seemed willing or able to clarify who was writing the inflation protection. Primarily on this basis, I advised the Adnams trustees to avoid LDI, which they did.”