The UK’s LDI crisis was one of the most shocking events in the financial markets in 2022. What went wrong and what happens now?
Not many people would have had a liquidity crisis in pension funds threatening UK financial stability on their 2022 bingo cards. But that is what happened in the immediate aftermath of the UK’s then Chancellor of the Exchequer Kwasi Kwarteng delivering his “Growth Plan” to the House of Commons, promising the biggest package of tax cuts in 50 years.
The pound dropped to its weakest point against the US dollar since the early 1970s, and 30-year Gilt yields, which had risen by 283bp over the previous three years, soared by 120bp in just three days.
The result was a crisis for defined benefit pension schemes following liability driven investment strategies.
Pension fund LDI strategies use derivatives as protection against adverse movements in interest rates and inflation and to release capital to invest in growth assets. But with Gilt prices dropping, funds suddenly had to cover margin calls on their derivative positions and had to sell most liquid assets – Gilts – to raise cash to do so. Mr Firesale meet Mr Vicious Cycle.
The disastrous feedback loop only ended when the Bank of England stepped in.
On September 28, it announced “temporary and targeted purchases of Gilts to help restore market functioning and reduce any risks from contagion to credit conditions”. Long-term yields plummeted.
“It was an unprecedented time in the Gilt market,” said Adam Gillespie, a partner at XPS Pensions Group. “Yields moved more in a couple of hours than they had in a year. Within half an hour of the BoE announcing its first intervention, yields fell by about one percent.”
The BoE later expanded the scope of its purchases to include index-linked Gilts.
Some voices had been warning about the risks of LDI strategies, but the developments were so shocking because until that point they had worked as intended for decades.
“Operationally, LDI strategies were set up to withstand short-term market movements greater than the worst ever seen,” said Alex Lindenberg, a managing director in Redington’s investment consulting team.
And pension fund managers had until that point coped relatively easily with the uptick in inflation and interest rates over 2022. “Capital calls were being made as interest rates were going up, but trustees had plenty of time to make those calls and to ensure hedging remained in place,” said Gillespie.
It was the speed and magnitude of market movements in September and October that far exceeded previous experience, forcing schemes already low on liquidity to sell liquid assets to fund margin calls.
“If a pension scheme applies leverage to LDI, then this frees up additional capital to invest in growth assets. If this extra capital was excessively allocated to illiquid assets or private markets, this meant that there were fewer liquid assets available to raise cash for collateral,” said Jos North, an investment director at investment management company Ruffer. “What didn’t help was the correlation in the market; everything was going down in price at the same time. There were no buyers.”
The sell-off led to speculation of significant losses, with Iain Clacher of Leeds University Business School, in a written submission to the Work and Pensions Committee, suggesting that “schemes can have seen the destruction of capital to the tune of around £500bn”.
“I think it will take some time to find a true number on any losses,” said Gillespie.
Cash and collateral
What is clear, though, is that there will have been a range of outcomes at different pension funds. In particular those that had to clear their derivatives positions in cash will have been affected most dramatically.
“It's critical to distinguish between institutions that would have used the cleared derivatives markets for their derivative strategies, and those using the bilateral OTC market,” said Simon Hotchin, a consultant advising the insurance industry (and former co-head of the solutions team at HSBC). “If you're using the cleared markets then your variation margin must be cash. The problem with that is that pension funds and insurance companies don't generally hold a lot of cash because it's inefficient for them; it doesn't help you match your liabilities.”
Following the financial crisis of 2008, the markets moved towards centralised clearing of derivatives to mitigate credit risk. And centralised clearing requires that variation margin is posted in cash.
“The problem in having cash variation margin calls is that it effectively creates liquidity risk,” said Hotchin. “For banks, it's fine because they hold cash and are adept at managing liquidity risk. Real money investors are not used to running large amounts of cash on their balance sheets and they're not used to managing liquidity risk because their liabilities are illiquid.”
Institutions clearing bilaterally, on the other hand, could post Gilts and corporate bonds as part of their credit support annex agreement with counterparties, which meant less stress on liquidity management.
Pension funds are currently exempt from clearing OTC derivatives. The exemption in the European Union will come to an end in June 2023, but the UK now falls outside of this ruling and could continue to allow the exemption if it chooses.
“This is one area where there could be a Brexit dividend of differential regulation,” said Hotchin.
Internal governance was another issue that prevented timely covering of margin calls. But it wasn’t necessarily the biggest schemes that proved most efficient.
“Many small schemes have streamlined governance systems so can easily transfer money within a manager from one fund to another,” said Gillespie. “Those with more complex governance structures may have funds with multiple managers, slowing down the transfer of money from manager A to manager B.”
It was in the “pooled funds”, making up 10%–15% of the LDI market, where Gilt market volatility had the greatest impact. With funds slow to transfer money, pooled LDI managers became forced sellers.
So what happens now? One thing is certain: regulations governing UK pension funds will have to be updated.
“Regulators will limit the amount of leverage in LDI funds, and they will increase the level of existing collateral held to withstand a 300bp–400bp move in Gilt yields, whereas previously, in some instances, it might have been below 100bp,” said North. “They will also require schemes to prove their collateral management frameworks. You might have to submit a stress-tested framework for the collateral you're going to use and at what point it will be triggered.”
Prepare for change
Fitch predicts the demand for extra collateral will push more UK DB pension funds to seek pension risk transfer deals with life insurers over adopting LDI arrangements with asset managers.
“For most pension schemes, the ultimate objective is for an insurance industry buyout and that buyout number has come down since Gilt yields have risen,” said Gillespie.
Under a buyout, the insurer makes all pension payments directly to scheme members in exchange for an upfront premium and that upfront fee has decreased as pension scheme funding positions and liability valuations have improved with the increase in interest rates. Despite the volatility in Gilts, many schemes found themselves in a better position in terms of their long-term liabilities by the end of 2022 than at the start.
“We carried out a survey in October that revealed some 60% of schemes had seen an improvement in their funding position over the year," even after the crisis, said Gillespie.
The next couple of years are likely to be busy for both insurance companies and pension funds as buyout plans are brought forward and participants enter a protracted period of precisely matching insurance policies to scheme members’ benefits.
The process is likely to necessitate a change in investment strategy as funds rebalance asset portfolios to accommodate the transfer.
“Funds will need to be in Gilts, corporate bonds, and liquid assets,” said North. “Insurers are not going to take on exposure to illiquid and private markets. If a scheme was on a trajectory for a buyout in 2035, that could now be by 2028 and you need to think about how you can prepare your scheme for buyout by 2028.”
The move away from illiquid assets will also be evident for those continuing to pursue LDI strategies that require additional collateral buffers. “Pre-crisis, there was limited value in differentiating between daily, weekly, or even monthly dealt funds,” said Lindenberg. “But in a fast-moving Gilt market, the ability to rebalance quickly becomes very important. We can expect pension schemes to focus more closely on liquidity terms, and favour more liquid investments.”
As part of the portfolio rebalancing, North suggests that corporate DB pension schemes will be sellers of illiquid assets for the rest of this decade. “Following the crisis, and for the next five to 10 years, liquidity will be the lens through which everyone's going to be looking at their asset allocation,” he said.
But there is a hint of irony in regulators enforcing a heightened focus on liquidity when the UK government is, at the same time, encouraging pension funds to invest in the country’s infrastructure assets as part of its transition to a greener economy.
Pension funds, particularly DB schemes with their long-term investment time horizon, are widely seen as perfectly placed to hold the type of infrastructure assets required to meet the government’s net-zero transition aspirations. But those assets are particularly illiquid.
“If the regulator doesn't allow pension funds to remain exempt from clearing and the banks don't have the appetite for more flexible arrangements on CSAs, then pension funds are going to have no choice but to run with higher allocations to cash and liquid assets,” said Hotchin. “And that is going to run counter to the government’s objectives in the infrastructure funding space.”
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