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LDI and the Liz Truss mini budget:
One year on, what - if anything - has changed?

September 2023

First published in Pension Expert

Twelves months after Liz Truss’ mini budget exposed weaknesses in liability driven investment (LDI), Pensions Expert looks at what, if any, lessons have been learned.

The crisis caused by Liz Truss’ disastrous mini budget has been a catalyst for change and encouraged a more forward-thinking approach to pension management.

This statement sounds prosaic but is a view shared by some in the pensions industry, a year after a mini budget, which unveiled £45bn of tax cuts, sparked an economic crisis which led to a run on sterling and exposed weaknesses in liability driven investment (LDI): LDI is a strategy which had been used by many pension funds to manage risk.

Paul Wood, founder of C-PAID, said: “The LDI crisis has been a catalyst for change so there has been a silver lining here, prompting a re-evaluation of existing strategies and encouraging a more forward-thinking approach to pension management."

He added that last year's LDI crisis had left an ‘indelible mark on the pension landscape’ and brought to the fore several underlying issues that have been simmering beneath the surface for years.

“The crisis has underscored the necessity of maintaining a buffer, a reserve of sorts, to cushion against unforeseen market volatilities. "Pension schemes are now more inclined to adopt strategies that allow for a degree of flexibility, facilitating a more dynamic response to market fluctuations.

“There is a growing recognition of the need to diversify investment portfolios to include a broader range of assets, including alternative investments that were previously considered too risky or unconventional. This shift is driven by a desire to hedge against the kind of risks that precipitated the LDI crisis, creating a more resilient portfolio that can withstand shocks in the future.”

The crisis served as a "wake-up call" to the UK's defined benefit (DB) industry, claimed James Borshell, senior employee incentives solicitor at Harper James.

He said: “For years, the DB sector had been guided by advisors and regulations towards reducing risk, especially in the balance between open and closed schemes and the ageing profile of these schemes.

“Gilts and liability matching through LDI were seen as ideal solutions. Gilts, being low on the risk scale, appeared to be a perfect match for long-term liabilities when applied through LDI. Understandably, trustees embraced this seemingly flawless product to safeguard their members.”

The pandemic effect

Borshell added that the world economy underwent a seismic shift due to Covid-19, leaving behind an era of low interest rates and low inflation.

He said: “This new environment constrained government actions and penalised deviations from consensus. The consequence of the Truss mini budget was that LDI investments entered uncharted territory, necessitating government intervention to prevent a mass collapse of leveraged 'risk-free' investments.

“Trustees engaged in intense debates on meeting their obligations to members when even the safest investments could lead to margin calls or extreme fluctuations in value.

“Employers, who had relied on trustees to eliminate risk from their legacy DB schemes, discovered there's no such thing as a truly risk-free investment.”

He added the crisis also signified: "A much-needed revaluation of investment strategies and a recognition that a one-size-fits-all approach no longer suffices in this evolving landscape."

“The critical question is how The Pensions Regulator will respond to this near disaster and the lessons it will take from it. As much of the push for LDI solutions and de-risking has originated from the UK's regulatory framework, the regulator will likely engage in self-reflection and may need to recruit new talent to adapt to a changing world where a uniform approach no longer applies, even if employers are willing to support it financially.”

LDI: What happens next?

Dan Richards, client director at ZEDRA, said the LDI crisis was a ‘Black Swan’ event.

The daily movements in gilt yields, which were fuelled by a feedback loop, transformed the value almost overnight of what should have been a stable long-term investment, and the speed with which it happened was unprecedented.

Richards said: “As with all black swan events, this one is now in our lexicon, so we can plan for it and mitigate emerging risks. There has been a big focus on liquidity of assets, ensuring that schemes have appropriate fallback plans should their usual sources of cash dry up. A weekly traded account is no longer good enough when we know we faced collateral calls within 24 hours during the crisis.”

He added that a positive to come from the crisis is that it has led to an increase in gilt yields, which has driven lower liability valuations across the UK DB sector.

Richards said: “A potential positive to come out of this event is that the increase in gilt yields has driven lower liability valuations across the UK DB sector. There has been a step change in liability levels, and almost overnight the quantum of the pension problem has been reduced.

“We don't often pay our investment advisors to lose money, but that is what happened last year, and many schemes that had well-constructed hedging strategies have emerged from this crisis with a sparkling bill of health.”


Beyond pension funds

Ben Amenya, investment consultant at Quantum Advisory, said the mini-budget of September 2022 created a significant turmoil in the pension industry that extended to the wider economy. This was characterised by an aggressive rise in yields, which prompted cash calls above what was expected at short notice from pension schemes to prop up the free-falling of LDI asset values.

Many schemes did not have sufficient liquid assets to meet the urgent calls and had to resort to selling some of their growth assets to meet the call.

“A year on, we have seen further aggressive rate rises to combat rising inflation not seen in decades, alongside heightened market volatility. These have had specific implications for LDI portfolios and pension schemes.”

Amenya said he has seen a larger number of pension schemes either switch out of LDI completely or have reduced their LDI allocation in favour of long dated unleveraged physical bonds. This is partly in response to the lower leverage available across LDI funds, and partly due to the additional collateral requirement.

“In an attempt to reduce the risk levels in LDI, the actions of regulators have resulted in the typical pooled LDI portfolio leverage falling to 2.5 times, from levels of around 3.5 times. The implication of this is that the same level of LDI allocation now provides pension schemes with lower interest rate and inflation protection than it did before. At those lower levels of protection, the use of long dated physical bonds looks more attractive.”

The additional collateral requirement also puts a tight squeeze on the asset returns of pension schemes, especially those that are underfunded, potentially reducing the expected returns on schemes’ portfolios as whole at a time when it’s needed the most.

“Set against this increasing collateral requirement, it is natural to see Trustees considering the impact of any future calls on return objectives and how to protect remaining growth assets. This could even see hedges partially unwound in future.”

LDI losers

James Bingham, partner at Sackers, said although it may be difficult to describe any scheme as ‘winning’ in the immediate aftermath of the LDI crisis, there were clearly some schemes which lost out significantly. Schemes which suffered particularly large losses are now carefully assessing where responsibility for this might lie.

He added: “Although the crisis arose following the mini-budget, the fact that its impact was not uniform across all schemes with LDI does lead to questions around why some schemes suffered losses and others didn’t. Trustees are rightly considering what their loss is and this, in itself, is likely to be a matter of debate and looking at the actions taken by their LDI manager and investment consultants in light of their contractual obligations and their general duty of care in carrying out these functions.”

Interestingly litigation may be being considered by some.

He said: “Investigation and preliminary correspondence with those involved can narrow the scope, reveal facts that bring the litigation to a close or even lead to a swift settlement.

"With a likely 6-year time limit from the date of loss to bring action, many of those affected are rightly taking the time to assess the impact on their scheme in the context of the recent favourable market for risk transfer rather than jumping immediately into formal legal action. Whilst it is early stages for many of these potential claims, there has been a clear appetite from some trustees and employers to seek to recover their losses notwithstanding the complexity involved.”

Liquidity management

Glenn Cameron, senior investment consultant and head of digital assets at Cartwright, said that the LDI crisis did not affect all DB pension schemes uniformly.

He said: “Schemes that were under-hedged benefited from the surge in yields. A minority of Schemes could not meet collateral calls and had to re-establish their hedges at lower yields than where exposure may have been lost, and therefore faced declines in their funding positions. Some schemes were sourcing collateral from volatile asset classes such as equities or long dated corporate credit which had to be sold at stressed levels, and because that capital was expended, it never recovered."

“ This divergence in outcomes highlights the importance of effective risk management, the importance of designing portfolios with appropriate collateral sources for LDI leverage rebalancing events, and the potential consequences of inadequate operational setup and procedures for managing LDI leverage rebalancing effectively.”

He added there is now an increased focus on liquidity management

Cameron said: “Maintaining liquidity has been highlighted as a paramount concern for pension schemes. Liquidity is essential for covering cash flow deficits, meeting collateral requirements for LDI strategies, and preparing for potential buyouts. The gilts crisis underscored the importance of liquidity management in DB pension schemes.”

However, Rhian Littlewood, senior business development manager at Standard Life, said it has not been all doom and gloom. The increase in gilt yields caused by the mini budget had an overall positive impact on the funding positions of DB schemes, with a greater reduction in their liability values compared to their assets.

Littlewood said: “As we approach nearly one year on from the Truss mini budget, the pensions landscape now looks very different, and especially the de-risking market. The increase in gilt yields caused by the mini budget had an overall positive impact on the funding positions of DB schemes, with a greater reduction in their liability values compared to their assets. Many schemes were already on a journey of improving funding levels due to employer contributions and positive investment performance, but for some schemes the mini-budget triggered a further unexpected improvement.”

She added schemes that successfully navigated that period, may now have a much-improved buy-out funding position, which launches them forward on their de-risking journey.

This was echoed by Rachael Healey, partner at Reynolds Porter Chamberlain, who said trustees have come out of last year's crisis stronger and are better equipped to deal with any calamities in the future.

She said: “Trustees have come out of last year's crisis stronger, now having lived experience rather than relying on theory. If the same crisis were to happen again tomorrow, they’d likely be better equipped. With that said, it’s possible some are looking back with a touch of overconfidence.”

Glenn Cameron is a Senior Investment Consultant at Cartwright.


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