Columbus’s egg and leverage in LDI

After Columbus’s discovery, a Spanish noble commented: “Mr Christopher, even if you had not found the Indies, we should not have been devoid of someone who would have attempted the same that you did, here in our own country of Spain, as it is full of great people clever in cosmography and literature.” 

Hearing that, Columbus asked for an egg (bear with me) and invited all around to stand it on its tip. When everyone failed, he gently pressed the egg on a table, flattening the bottom and resting it in place. “After the deed is done, everybody knows how to do it,” he said. 

Contingency plans were in place

There is a risk of commentators appearing like Spanish nobles in current discussions regarding the resilience of schemes’ use and management of liability-driven investments. It is therefore important to retain a clear recollection of how LDI was viewed and understood before September 23 2022.

We have seen that LDI has stabilised funding levels for the majority of the modern history of our pensions industry

At the same time, identifying the factors that have contributed to schemes’ liquidity crisis, and commenting on what could have been done differently, should not be dismissed as an attempt to gain the intellectual high ground through hindsight.

We should remember that, according to the Bank of England, the largest users of LDI among UK pension schemes had contingency plans in place to withstand an instant 100 basis point rise in gilt yields at all maturities — and yet, falling gilt prices across just three days of trading pushed yields up by 160bp.  

It has been said this was a one-in-400-year event, or an event with a probability of less than one in 1,000. Some may therefore consider it reasonable enough that contingency plans did not cater for what happened. But that should not lessen the need for reflection on what it was about LDI that left our pensions system exposed, and created the risk of another financial crisis.

It is early days and schemes will want to consider this carefully for themselves once the current emergency has passed.

However, events since September 23, taken with a balanced assessment of experience over the previous 20 years, may support a conclusion that the problem is not the strategy of LDI investing per se, but the effects of using leverage when doing so. For we have seen that LDI has stabilised funding levels for the majority of the modern history of our pensions industry and, when schemes were required to post collateral as gilt yields gradually rose through 2022, margin calls were met in an orderly fashion. 

The problem came when gilt prices collapsed suddenly, and not only were schemes out of the money under their swap contracts, but the value of the collateral pools these were topping up was falling too.  

Aiming at a moving target

Schemes were trying to rebalance by chasing a target that was moving away from them. But the risk of that happening, and the extent of its impact, was exacerbated by the levels of leverage in place. And there was a particular problem for pooled funds that faced being wound up, causing a mass sell-off of the gilt collateral then swept in by their bank counterparties.  

Other factors may be considered to have contributed too, including an underestimation of “black swan” events, insufficient prudence when reserving for potential collateral calls, and a failure to regulate against the systemic risk of things unwinding. 

Going forward, schemes may begin to view their use and management of leveraged LDI differently in light of what recent events have shown about the compatibility of leverage with the requirements of regulation 4 of the Occupational Pension Schemes (Investment) Regulations 2005.

This says that derivatives can only be used insofar as they contribute to a “reduction of risks” and must be managed to avoid “excessive risk exposure”. So, while LDI itself does that, the use of leverage reintroduces risk — and, as we have seen, this can have profound consequences if a “low-probability, high-impact” event occurs.

Perhaps if Columbus were around today, he would say this could only be known after the egg is standing on the table, but nevertheless it is known and we will probably now see steps taken to address leverage.

Simon Daniel is a partner at Eversheds Sutherland