The author is a finance and economics commentator and former global head of asset allocation at Columbia Threadneedle Investments
The £1.5billion number is significant – at least in a UK context. It accounts for 40% of the UK institutional asset management market, two-thirds of gross domestic product and around the size of total government debt, after removing bonds held by the Bank of England.
This is the amount of liabilities held by UK pension funds that have been covered by what are known as liability-driven investing transactions, according to the professional asset management body The Investment Association.
LDI is a big company, having more than tripled in size over the past decade, and the reason is simple: it helps funds manage risk by delivering on their pension promises to members, in part through derivatives. .
But now the funds are facing calls from counterparties to provide collateral to fund these deals. The sums are potentially huge, and asset sales to meet calls could have a ripple effect in markets such as equities.
Over the past 25 years, falling and falling long-term bond yields have created a costly headwind for pension funds. Thousands of companies that sponsor defined-benefit pension plans — usually now closed to new entrants — have seen the book value of their liabilities soar. When bond yields fall, the present value of these future liabilities is discounted at a lower rate.
The pension regulator estimates that every 0.1 percentage point fall in UK gilt yields increases a conservative measure of the UK scheme’s liabilities by £23.7 billion. In the decade to December 2020, long-term 25-year gilt yields fell by more than 3.5 percentage points and plan liabilities rose by £960bn (about 40% of GDP) .
Pension plans cannot control wild swings in the value of their liabilities. But they are not completely helpless. They can invest their assets in such a way that they become relatively indifferent to fluctuations in the bond market, and this is where LDI comes in.
Since bond prices determine the valuation of pension liabilities, transferring pension assets to bonds will effectively hedge liability volatility. The problem is that few pension plans are funded enough to do this business. Instead, schemes invest part of their assets in bonds with liabilities and part in growth assets – corporate credit, stocks, real estate. They then hedge the risks of this strategy with derivatives, using bond assets as collateral.
The hope is that growth assets will produce decent returns and make them fully funded while derivatives will desensitize them to future interest rate swings. The results were good, but also left pension funds as counterparties to huge amounts of leverage in the financial system.
Despite £1.5bn invested in LDI strategies, UK pension funds remain underhedged. So while the rise in long-term bond yields in recent months has been bad news for their yield-seeking holders, it’s great news for funding pension plans.
Since the end of 2020, long gilt yields have risen by 1.7 percentage points, helping move a third of UK DB pension schemes from deficit to surplus. The UK Pension Protection Fund has found that system-wide funding of pensions has improved £350 billion over that period.
But this rise in yields comes with significant losses and collateral calls for systems engaging in leveraged LDI derivatives trading. Wide how? A higher estimate, if LDI were implemented entirely via derivatives, would be a collateral call of over £380bn – but in truth, we don’t know the precise mix of bonds and derivatives deployed.
To be clear, that was the plan: the losses were to match the declining liability values of the scheme. Thus, funding ratios should not be affected. In addition, plans that engage in LDIs will have upside stress-tested yield environments and appropriately sized collateral to withstand such a shock. However, bond yields rose more than the standard stress tests expected, largely or entirely wiping out the plan’s buffers. Those plans with depleted excess buffers must now decide how and when they will restore them.
Is it important? The managers of LDI claim that their activities pose no systemic risk, and I read the silence of the Bank of England’s Financial Policy Committee as agreement. But UK pension funds are collectively very large derivative counterparties and they move together.
The scheme’s buffers have been significantly depleted in all areas and need to be replenished; this can only realistically happen by selling growth assets like corporate debt, stocks and real estate. So while rising yields are good news for pension plan funding levels, they appear to be a likely catalyst for further liquidation of risky assets.