While making their bid to overhaul the pension system to one of Britain’s largest retailers, next chief executive Lord Simon Wolfson recalls that the advisers were “very confident”.
The advisors promised that “responsibility-driven investing” was a stress-free way to protect the fund from fluctuations in interest rates using derivatives.
There is a certain phrase that has stuck in Wolfson’s mind since the 2017 meeting: “You put it in a drawer, you close the drawer and you forget about it.”
But Wolfson and his team ultimately rejected the plan. “If you just take the historical data, it looks very strong,” Wolfson said. But the great lesson of the financial crisis is that you cannot look to the past as a foolproof way to predict the future. In the end, we didn’t care what the spreadsheets said: We didn’t like its smell, so we decided not to.”
Next went so far as to warn the Bank of England that LDI strategies, which it has currently invested £1.5 trillion in the UK, “look like Time bomb Waiting to explode.”
Came last week blast. After Chancellor Kwasi Quarting announced a £45 billion unfunded tax cut on September 23, sterling fell and UK government bond yields rose over the next few days on hopes of increased borrowing.
The UK’s defined benefit system obligations are measured against these long-term interest rates and, in general, higher returns are beneficial, as they reduce the liabilities owed by companies to retirees.
But LDI strategies use a variety of derivatives to allow pension plans to increase their exposure to gold, without necessarily owning bonds. When bond prices fall, counterparties demand more cash as collateral to keep the arrangement in place.
The sudden drop in gold prices led to a rush of cash calls. To raise funds, the funds were forced to sell assets, including gold bonds, which further lowered prices and risked a “doomsday ring”.
“The speed and scale of the move in the gold bond market has been unprecedented,” said Simon Bentley, Head of UK Solutions Client Portfolio Management at Columbia Threadneedle. “You’ve had nearly four consecutive days of ‘black swan’ in terms of market moves.”
Responding to calls for help from the pension and asset management industry, Bank of England intervention Last Wednesday, he promised to buy up to £65 billion of long-term bonds to stabilize the market.
“The crisis event was not in anyone’s models, but it was not entirely unexpected,” said Ovin Devitt, chief investment officer at Moneta Group, a financial advisor.
The UK’s adoption of the LDI has its roots in a major accounting change in 2000, which forced companies to admit deficits to pension funds on their balance sheets.
When the rule was introduced, David Konuti Ahulu was the managing director of Merrill Lynch in London, where he worked in the bank’s pension and insurance solutions group. He said the new accounting standard was a “game changer” for British companies, as it pushed defined benefit plans, which promise to pay employees’ pensions at a fixed level, sometimes on the basis of their final salary, into “uncertainty”.
“They simply didn’t know if they had enough assets to pay pensions to all of their members when due,” and it also made it difficult for corporate sponsors to plan or invest in the future.
Konotey-Ahulu was part of a team at Merrill that developed the LDI in an effort to “immunize” defined benefit schemes against large moves in interest rates and inflation. By 2003, he had offered the strategy to more than 200 companies without finding any recipients. Finally, after a long series of discussions, the Financial Services Group Provident friends agreed Adoption of the LDI strategy for the pension fund. It entered into a series of long-term inflation swaps with Merrill to ensure that there was no decline in real returns.
Since then, a full-fledged industry selling, managing and advising on LDI strategies has grown. For asset managers, including legal and public investment management, Insight Investment, BlackRock and Schroders, it is a low-margin but high-volume business. The largest schemes hold the bulk of their LDI assets in separate mandates, with fees ranging around 0.1-0.2 percent per year but may cover 80-90 percent of system liabilities. Smaller clients tend to team up in pooled funds to take advantage of the range and lower prices. Most of the recent problems have been in bulk chests where agility is reduced.
Despite the recent turmoil, Konuti Ahulu remains one of the biggest proponents of LDI and says the core concept still intact. But even he concedes that their complexity is a problem, with difficult collateral management and an orchestra of tools from gold total return swaps to gold repo contracts and inflation swaps. “Undoubtedly the problem is that people don’t really understand it,” he said. “It’s like trying to explain some aspects of quantum physics to people who aren’t really physicists.”
Consultants are often the main advocates. “Investment advisors love LDI,” said Eddie Troell, former head of the London Pension Fund Authority, who now runs private equity group Disruptive Capital. “It’s wonderfully complex so no one understands it and so they can look smart and earn fees. For about 99 percent of trustees, that’s not entirely clear.”
David Valerie is chief executive of the Lothian Pension Fund, which has £8 billion in assets in stocks, bonds and alternatives – but is not exposed to LDI. “We are not sophisticated enough to fully understand it,” he said. “And quite frankly, we don’t have the resources to fix it if something goes wrong.”
But within the British pension fund community, the skeptics were very much an exception. The LDI program has been widely adopted by the UK’s 5,200 defined benefit schemes, which have more than 10 million members and £1.5 trillion under management.
The schemes and asset managers say that in the market environment that has characterized the past two decades, they have proven effective. The bullish global bond market has driven up prices and lowered yields, meaning pension funds that weren’t hedged against these moves find themselves trying to generate returns to meet ever-increasing liabilities. A lack of or inadequate hedging at companies such as construction group Carillion and retail group Arcadia has been a contributing factor to its bankruptcy, according to pension experts.
Professional services firm PwC estimates that pension funds have moved from a deficit of £600bn a year ago to a surplus of £155bn. Liabilities were halved from £2.4 trillion to £1.2 trillion. More than 20 per cent of the Bank of England’s pension funds were in deficit in August this year, and more than 40 per cent were in the previous year, according to the Bank of England.
“LDI has saved schemes from huge, untenable deficits and has saved sponsors from constantly increasing schemes,” said Andy Connell, head of solutions at Schroders, which has $55 billion in its global LDI business. “They were able to keep cash in the business for wages, investment and profits. LDI strategies have been hugely beneficial to society for the UK company and the economy.”
Although the BoE’s intervention calmed the market, it did not end the pension schemes’ rush for cash. Counterparties have called for more collateral to reduce derivative risk. And there are concerns that when the Bank of England’s two-week bond-buying program ends next week, volatility will return.
“We see a lot of activity that would normally take months in the pension fund world in a matter of days,” said Callum McKenzie, investment partner at Aon Advisory. “This puts a lot of pressure on the system.”
Nikesh Patel, head of client solutions at Van Lanschot Kempen, thinks pension schemes in total should offer up to £280bn to fully recapitalize the interest rate and hedge against inflation with new low levels of leverage. This is on top of the £200 billion that schemes already had to provide to meet the LDI guarantee calls.
One option is to forgo LDI strategies entirely but that leaves pension plans vulnerable to future fluctuations in rates and inflation.
“Initial indications are that most of our clients would like to keep their hedge ratio intact and provide us with more collateral,” says Sonja Laud, chief investment officer at LGIM.
Trustees who can be held personally liable for pension losses are being asked to hastily approve asset sales even though the exact financing status of many schemes remains unclear as a result of recent market volatility.
In a note seen by the Financial Times, chancellor Barnett Waddingham advised a scheme to sell nearly 20 per cent of its assets despite the uncertainty surrounding its finances.
Pensions continue to sell yield-seeking assets — including exposure to property, corporate debt and private credit — and exchange them for cash and gold, in order to prepare for demands for liquidity. They are trying to avoid being forced to sell private assets at a huge discount.
All this in order to get their portfolios in order before the Bank of England removes its support for the gold bond market on October 14. “The BoE’s intervention did not erase the problem,” said Dan Milley, partner at advisory firm Mercer.
The Bank of England has indicated that it will not extend its gold buying facility beyond next week, according to market participants. Keren Rosenberg, CEO of Cardano, an advisory firm and investment manager, is urging the BoE not to consider “mission accomplished” on October 14. “The bank should be prepared to take that action again, if it needs to,” he says. While the industry is able to withstand more fluctuations that are not without limits. We know from our portfolio and from our clients that there is only a certain amount of collateral buffer.”
Advisers said there may be lawsuits in the future. Questions are raised as to whether there is adequate regulation of the sector. The UK pension regulator claims the system has “dealed” with last week’s market turmoil, but MPs will scrutinize the watchdog over its role in overseeing thousands of pension schemes caught in the crossfire.
Investment advisers, who faced calls for more regulation after property funds closed in the wake of the Brexit referendum, are facing new scrutiny. The Financial Conduct Authority conducts a “lessons learned” exercise with asset managers.
Meanwhile, regulators, asset managers and pension schemes globally are looking at the UK as a test, trying to absorb the potential impacts on their markets. “It was a real eye opening,” said Ariel Bazilal, fund manager at Jupiter. “Everyone freaks out and asks: What just happened to these UK pensions with these LDI strategies? Is there anyone else out there or another country that could get hit?”
But some worry that the soul-searching won’t go far enough. “Managers communicate the assumptions of their models for a status quo that might be a good development,” Devitt said. “I’m not sure if we’ve just put a Band-Aid on the problem or actually examined it structurally… I’m not sure that a change of mind is happening fast enough to know if it’s the right solution for the next system. We tend to go to the last war. “.
Additional reporting by Kate Bewley, Katie Martin, Caroline Benham, Owen Walker, Tommy Stubington, Joshua Oliver, Jonathan Eli, Alex Parker and Laura Noonan