Nearly five months on from the gilt market crash, disagreement on the impact of the LDI crisis continues, as was illustrated by the Work and Pensions Select Committee hearing on 1 February. A key question to be resolved remains who were the winners and losers of September’s market rout.
A shift to bonds
The hearing kicked off with a brief history lesson as members considered the wider economic impact of the introduction of FRS17 accounting standards and the 2004 Pensions Schemes Act.
The witnesses were Tim Bush, head of governance and financial analysis at Pensions and Investment Research Consultants; Professor David Blake, director of the Pensions Institute at Bayes Business School; Toby Nangle, a former fund manager and independent economist; and Sarah Breeden, executive director of financial stability strategy and risk at the Bank of England.
Blake pointed out that the introduction of FRS17, which puts pension scheme liabilities onto corporate balance sheets, accelerated the shift of defined benefit (DB) assets into fixed income from equities as sponsors worked to minimise any impact on their accounts.
This has had dramatic consequences for UK plc, added Toby Nangle. “Pension funds could continue to invest into things like infrastructure and other long-term assets but they were now investing less in equities,” he said, adding that someone else had to buy them.
“And that typically went to international investors,” Nangle said. “So, the UK, compared to pretty much any developed country, has had a higher degree of international takeovers of their businesses.”
On average, DB schemes have almost a fifth (19.5%) of their portfolio invested in equities, down from more than 60% in 2006, according to the Pension Protection Fund (PPF).
Nangle also highlighted that with the introduction of the 2004 Pensions Act, part of The Pension Regulator’s remit became to safeguard the solvency of the PPF, which meant minimising the risk of potential claims against it. This in turn meant that the PPF paid greater attention to the size of a scheme’s liabilities.
There’s a tuna fish in my paddling pool
But this shift towards bonds increasingly evolved into a systemic risk because of the dominance of DB schemes in the gilt market and the sheer volume of schemes pursuing such a strategy.
“Total LDI assets stood at £1.6trn, according to the Investment Association,” Nangle said. “To put that into context, UK government debt is £2.4trn, of which about £800bn is held by the Bank of England. So, it’s not so much like a big fish in a small pond, it is more like a tuna fish in a paddling pool.
“Any swivelling of the tail can destroy the whole structure and if they are all invested in the same way, that can really unsettle the market,” he added.
This stands in sharp contrast to the situation in the Netherlands, where pension funds navigated a similar crisis with fewer consequences as they easily absorbed large trading volumes.
Paradoxically, one of the winners of last year’s gilt market turbulence was the Bank of England, which intervened between September and October to buy more than £19.3bn of long-dated conventional and index-linked gilts. It later re-sold them for £23.1bn. According to Tim Breedon, this suggests schemes would have booked around £4bn in losses on their gilt investments alone because they would have sold the bonds in a falling market and bought as prices were rising again.
The Bank of England’s Sarah Breeden described intervention as successful in restoring market stability. She said that if the bank had not intervened, the damage caused by the crisis could have been far worse.
Death by “stupid accounting”
But while industry experts are clear on the symptoms of the LDI crisis, they continue to disagree about its causes and hence how the market could be made more secure.
Nangle said that existing accounting standards mean there is a mismatch between assets and liabilities and that schemes will continue to invest in fixed income to navigate that.
One response to the LDI crisis has been a call to ban leverage, a proposal put forward by John Ralfe, who first applied liability matching without using leverage for the Boots’ pension scheme.
But Nangle warned against this. “Removing the ability to use leverage would simply mean that you need to have a lot more invested in physical bonds and less in things which might be illiquid, such as infrastructure or private equity,” he said.
Tim Bush countered that by stating that accounting standards were at the root of the LDI crisis. He said they create an “odd hall of mirrors effect, which didn’t give enough credit for being invested in equities compared to bonds”.
One paradox of the LDI crisis is that despite booking dramatic losses to their assets, most DB schemes enjoyed better funding ratios because the value of their liabilities declined thanks to rising gilt yields.
To get an indication of the scale of the losses, in December the combined assets of final salary schemes stood at more than £1.4bn, down from around £1.6bn in July, the PPF said. That leaves £181bn unaccounted for. In turn, liabilities have fallen to £1bn, from almost £1.4bn.
But Bush warned that the reduction in the present value of liabilities was misleading, and that actual liabilities should be a lot higher, especially given the fact that in many cases, pension payments are inflation linked. “Something odd is happening with the maths, I am not sure they have done the algebra right.
“I would be concerned to assume that everything is healthy just because the liabilities have gone down. Actuaries to have a track record of getting things wrong,” Bush added.
For Nigel Mills, one of the MPs at the hearing, this raises the question of if DB schemes have been killed by “stupid accounting”.
Counting the cost
One key issue to resolve is the question of how big cash reserves should be to ensure that schemes will not be forced to sell their assets again.
The Pensions Regulator attempted to tackle this challenge with a new guidance on LDI that was sent to trustees in December. These recommendations acknowledge that previous risk management scenarios for bond markets did not factor in the potential scale of the crisis.
In the past, schemes were required to hold enough capital in reserve to shield them from short-term yield spikes of between 100 to 150 basis points. But in September, yields moved by nearly 300 basis points. In response, the regulator now recommends that schemes should hold reserves to cover rises of between 300 to 400 basis points.
Speaking at the select committee hearing, Nangle expressed confidence that these extra cash buffers should suffice to ensure that markets would not see a repeat of September’s crisis. But there is a snag to holding these additional reserves.
There are now cases of asset managers who are running LDI programmes requiring schemes to hold far larger cash buffers for scenarios of yield rises of up to 700 basis points, Nangle said.
These would also come with higher management fees. The Financial Times reported in October that Blackrock, a major provider of LDI strategies, had made more than 70 requests for additional cash to the schemes it worked with.
The extent of damage also varies greatly, depending on the manager schemes selected to execute their LDI strategy. Research by XPS Pensions revealed that among the five leading asset managers, on lost about 16% of its hedge due to not meeting collateral calls and forcing through a reduction of the hedge. Other managers only lost about 2% of their hedge throughout the same period. In general, schemes whose hedging positions had been cut the most tended to see a sharper deterioration in their funding position, the report said. XPS Pensions has downgraded three LDI managers to amber or red, meaning that it is advising its clients to review their commitments with the manager.
As the dust settles on last year’s market turbulence, it is starting to become more transparent as to who the winners and losers of the LDI debacle could be.
The real losers might not be today’s DB members, but those who retire in the decades to come, who will do so on significantly less generous pensions.
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