On 23 September 2022, the Chancellor delivered his mini-budget, prompting both nominal and real gilt yields to rise sharply due to the announcement of further government borrowing. The size and speed of these rises were unprecedented, representing one of the three upward moves in nominal gilt yields in the last 60 years.
Rising gilt yields are generally good news for most pension schemes – as gilt yields rise, the value of pension liabilities falls. The value of the scheme’s assets also usually falls in a rising rate environment, but typically by less than the liabilities. As a result, scheme funding levels have been improving over the course of the last decade.
However, liability-driven investment strategies (LDIs), used by many defined benefit (DB) pension schemes, have come under strain. The rapid rise in yields created a situation in which investors needed to pay collateral (i.e. cash) very quickly to support their hedging positions. Whilst in the face of the very rapid rise in yields, and concerns that the gilt market was becoming disorderly, the Bank of England decided to intervene in order to restore orderly market conditions, they have made it clear that it would be strictly time-limited. The Bank of England’s daily purchase of gilts would only carry on until 14 October, leaving DB pension schemes a limited window to review their positions.
What is LDI and why do so many DB pension schemes use it?
LDI, which has been around since the early 2000s, is an approach that focuses the investment policy and asset allocation decisions on matching the current and future liabilities of the pension plan. LDI shifts the focus away from beating benchmarks towards stabilising the funded status of the scheme, through the use of a hedging arrangement.
DB pension scheme liabilities are generally measured against prices of high-quality bonds. So, to maintain a relatively stable funding position, schemes invest in those bonds. However, high-quality bonds are expensive and putting all of a scheme’s assets into buying bonds means long-term growth will be limited. Historically, many schemes needed that growth in order to close deficits or to simply provide good pensions at a reasonable cost and, therefore, made use of LDI which allowed them to buy more high-quality bonds to help preserve stable funding positions while still retaining some long-term growth.
Generally, this has worked very well, as evidenced by scheme funding levels. However, as LDI hedging is implemented through derivative contracts, DB schemes are vulnerable to a requirement to pay in collateral to the hedging bank or LDI manager, to support their exposure to the market cost, resulting in liquidity issues.
Action by the Pensions Regulator
Whilst the Pensions Regulator (TPR) has been monitoring the situation, it has declined to take any action. Importantly, while DB pension scheme liabilities are generally measured against prices of high-quality bonds, there are other ways to measure this. There is also no particular investment approach imposed on any scheme and TPR guidance asks trustees to consider various issues and take advice where appropriate.
There has also been no indication of regulated leverage limits being introduced as TPR has historically taken the approach that it is for the trustees and those involved in investing the assets to make their own decisions based on their own circumstances.
Next steps for DB schemes
With the breather afforded by the Bank of England, most schemes have now managed to get some more cash to the LDI manager to keep their positions in place. However, the Bank of England has made it very clear that it is not going to support these markets forever, and it has been putting pressure on LDI managers to change the rules of their funds.
Those DB pension schemes that use LDI have a key strategic decision to make: whether to prioritise investment returns for the long term, or to prioritise hedging the funding position. For many schemes, the fact that they are so much better funded than ever before means that they can afford to take the latter option without many adverse consequences. They can keep their risk management tools in place with less leverage and accept lower growth investments because high growth to plug a deficit is no longer needed.
Affected schemes should take this opportunity to review their hedging levels and the cost of these levels against the long-term benefit to the scheme. However, it is important to distinguish between short-term investment changes that have been made to meet collateral requirements, and more fundamental long-term strategy decisions that are going to be required because of the new volatile financial climate. The former should not lead to a knee-jerk change in funding strategy and, for most schemes, the wait-and-see position might be the best course of action. The ongoing liquidity of the scheme should be considered in conjunction with any deficit reduction contributions being made by sponsoring employers.
These types of decisions around strategy will soon need to be considered against the backdrop of a new DB funding regime. For a more detailed look at our thoughts on the new funding regime, click here.