LONDON- It started out pretty simply: British pension plans were looking for a way to match their assets to future pension payments.
Plans are in place for pharmacy In the 2000s, retailers like Boots and WHSmith were among the first to switch from stocks to bonds as a way to protect their investments from changes in interest rates.
But fifteen years later, nearly two-thirds of pension plans now use financial derivatives instead of just bonds as part of their strategy. This adds a growing amount of risk to the plans, which is only now becoming clear as interest rates rise.
In the popular LDI, or liability-driven investment, strategy, pension plans would use derivatives, which are contracts whose value comes from one or more assets, to protect themselves from possible changes in interest rates. They could get big exposure with a small amount of capital.
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There is a catch, though. If the pension fund loses money on the derivative, for example because the price of the underlying asset changed, it can be called up for more money, sometimes at short notice.
For a long time, none of this mattered, and in 2018, consultants said the market would soon reach “The Age of Peak LDI” because it was so popular that the pensions industry was running out of assets to hedge.
In ten years, LDI’s assets went from 400 billion pounds to 1.6 trillion pounds ($1.79 trillion).
But, according to interviews with pension scheme trustees, consultants, industry experts, and asset managers, the strategy became more risky over time. Things started to go wrong when Britain’s “mini-budget” on September 23 caused yields on UK government bonds to go up. This made pension funds rush to raise cash to keep their LDI hedges in place.
These derivatives were almost worthless, so on September 28, the Bank of England promised to buy bonds to stop the panic.
Risks that seemed to be hidden during a decade of low interest rates were made worse by how much money was used in the LDI strategy and how much more was borrowed through derivatives.
People who were interviewed said that schemes were slow to act when rates started going up in 2022 and warnings about risk got louder.
“I’ve never liked the term LDI, and I never have. It’s been taken over by consultants and changed into what we’re seeing now,” said John Ralfe, who led the Boots Pension Fund’s move of 2.3 billion pounds into bonds in 2001. He told Reuters that the fund didn’t take on a lot of debt.
Ralfe said, “Pension schemes were hiding borrowing, which is a very bad idea.” “The financial system had a lot more risk than anyone, including me, would have thought.”
On Friday, Boots didn’t answer when asked for a comment. On Thursday, WHSmith didn’t respond when asked for a comment.
Now that interest rates are going up, investors around the world are worried about other financial products that were based on low rates.
The executive director of the World Pensions Council, Nicolas J. Firzli, said that the so-called LDI crisis in the UK is just a sign of a bigger economic problem.
RISKIER BETS
In the 20 years since Ralfe worked at Boots, defined benefit pension plans, which give retirees a set amount of money each month, have bought a lot of LDI and derivatives to borrow money and invest in other assets.
For example, if the leverage in the LDI strategy was three times, the scheme would only need to spend £3 million to protect a ten million pound interest rate.
Instead of buying bonds to protect against falling interest rates, which is a key factor in a scheme’s funding position, a scheme could cover 75% of its assets while only tying up 25% of the money. The rest of the money could be invested in other things.
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The rest of the money could be put into stocks with higher returns, private credit, or building up infrastructure.
The plan worked, and the funding deficits of the schemes got smaller because the hedges made them less vulnerable to falling interest rates. Because interest rates are low, pension plans have to keep more money in the bank for future payments.
Companies and regulators were happy about this.
Asset managers like Legal & General Investment Management, Insight Investment, and BlackRock (NYSE:BLK) offered LDI funds as a low-margin but high-volume business. The FCA, which oversees LDI providers, didn’t want to say anything.
Consultants like Aon (NYSE:AON) and Mercer tried to sell LDI to trustees, and the government agency in charge of regulating pension funds, The Pensions Regulator (TPR), pushed schemes to use liability matching to reduce deficits.
TPR says that LDI funds are used by nearly two-thirds of the defined benefit pension plans in Britain.
The plan worked as long as the yields on government bonds stayed below limits that had already been agreed upon and were written into the derivatives.
Nigel Sillis, a portfolio manager at Cardano, which offers LDI strategies, said that clients used to think of LDI as a “fire and forget” strategy.
He also said that the industry had been “a little blasé” about how much pension trustees knew.
Over time, the risk grew. A senior executive at an asset manager that sells LDI products said that leverage went up, and that some managers now offer customised products with five times leverage, which was not possible ten years ago.
Before 2022, pension plans were rarely asked for more collateral, and the executive who spoke on the condition of anonymity said that a risk-averse industry had become less careful.
TPR says that no scheme was at risk of going bankrupt. In fact, rising yields make it easier for funds to get money, but schemes didn’t have access to liquidity.
Still, the watchdog said this week that some funds would have lost money.
When yields went up in a way that had never happened before from September 23 to September 28, pension plans had to scramble to find cash for collateral. If they didn’t find it in time, the LDI providers cut back on their hedges, which left schemes vulnerable when yields dropped after the BOE’s intervention.
Nikesh Patel, head of client solutions at asset manager Kempen Capital Management, says that only a small number of schemes would have seen a 10–20% drop in their funding.
Simon Daniel, a partner at the law firm Eversheds Sutherland, says that pension plans are now setting up standby facilities with their sponsoring employers to get cash as collateral.
Risks in LDI have been pointed out for a long time.
This month, BOE deputy governor Jon Cunliffe said that the Financial Policy Committee of the Bank of England brought up the need to keep an eye on the risks of LDI funds’ use of leverage in 2018.
This year, there were more warnings, especially as rates started to go up.
Pensions consultants In June, Mercer told clients to “act quickly” if they wanted to make sure they had cash. AON told pension funds in July that they should be ready for “urgent intervention” to protect their hedges.
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CEO Charles Counsell said this week that TPR had always warned trustees about liquidity risk.
Consultants and trustees say that in the slow-moving world of pension funds, where investment strategy changes are often made over years rather than weeks, few funds were reducing leverage or increasing collateral.
After rates started to go up this year, some of the most sophisticated pension plans were even buying more LDI.
The Universities Superannuation Scheme, which is Britain’s biggest pension fund, decided earlier this year to increase its exposure to LDI, in part because of the “distinct possibility of further falls in UK real interest rates,” against which it needed to protect its 90-billion-pound portfolio.
Since late June, the yield on Britain’s 30-year inflation-linked bonds has tripled.
In a statement released this week, USS defended its strategy by saying that it had enough cash to meet margin calls and wasn’t being forced to sell assets. It said it didn’t mind if rates went up and it cost more to hedge.
That conversation had just begun somewhere else.
David Fogarty, an independent trustee at professional pension scheme trustee provider Dalriada Trustees, said that when people talked about interest rates, all they talked about was how interest rates were going down.
“Neither did there seem to be much talk about leverage.”
