Episode 6: Liability-Driven Investing (LDI) in Pensions: what really happened and what happens next?

Episode 6: Transcript

Raj Mody: Hello, and welcome to this episode of PensionsCast, a podcast where we discuss topical pension issues being faced by companies, pension scheme trustees, and pension scheme members. I'm Raj Mody, a partner at PwC, and I work with our clients in the UK and around the world on a wide range of pension issues. And last September 2022, the whole industry faced what seemed like an existential issue, the abbreviation LDI, which stands for liability driven investing, or liability driven investment, is now a much more well known abbreviation to pension stakeholders than it ever was before, this episode is about LDI. Joining me in the studio are Sam Seadon, an investment advisor in PwC's pension team, and I'm delighted to welcome Lauren Brady, who is a solution designer at Insight Investment, which is an LDI manager. This is the first episode of 2023, and we want to do and try two things, review what happened but really with a focus on taking out of that, what is relevant for forward planning for anyone involved in running a pension scheme. The situation is moving on a daily basis, just today, on the day of recording, in February 2023, the House of Lords has issued a report, well worth reading by the way, on the LDI situation, and so no doubt views and perspectives will continue to emerge as different groups and parties look at what happened and analyse it themselves, but we're going to give it a go today. So Lauren, let's start with you if I may, from your perspective working inside an LDI manager, please do talk us through what happened at the end of September 2022 until October 2022, obviously I mean I know there were things in the run up to that, so you may want to start your story a bit earlier.

Lauren Brady: Thanks Raj, and thanks for having me today. Yes, so, I think before we get into September and October, I think it's worth looking at the wider context throughout 2022. So, before that point there was, over the course of 2022, a lot of information around central banks hiking interest rates to curb inflation. We saw that not just in the UK but globally, and that led to Government bond yields rising throughout 2022 in most major markets. What then happened in the UK was that was exacerbated by the UK Government's mini budget on the 23rd September, and we saw UK Government bond yields really take off in response to concerns over some of the measures that were announced in that budget, and that led to, really, an unprecedented rise in Government bond yields, and as Government bond yields rise, prices fall. So to put that into perspective, the longest dated inflation-linked gilt with returns linked to inflation which matures in 2073, actually fell from a price of just over 115 down to 50. 115 down to 50 in just a few trading days, which is more of a performance reminiscent of Bitcoin rather than a UK security.

Raj Mody: Well quite, yes, and just to put that into context because it's worth saying again, so its value fell by over 50%? Its value halved in a matter of a few days, which is I think fair to say, as you've said, not something we expect from the UK Government gilt market. Okay, so then yes, what happened next?

Lauren Brady: Well, so then what happened is that there was a lack of liquidity in the market, so there weren't enough buyers in the market to purchase some of the gilts that were being sold. So that pushed prices down even further and yields up higher, and ended up with yields rising so sharply that the gilt market almost became dysfunctional, which was when then finally the Bank of England stepped in on 28th September. And that immediately, just their announcement even before people really looked through the measures, started giving the market a bit more confidence, and they had launched a temporary programme of purchasing long dated gilts until around mid-October. And then that actually marked a bit of a u-turn as well from their previous announcements where they had said they were going to start selling Government bonds, which was a reversal of their quantitative easing programme where they'd been buying up Government bonds in the previous few years. Then what happened is they announced further measures a week or two later on October 10th, 11th, and they allowed corporate bonds to be used to buy banks as repo collateral, they also increased their purchase of Government bonds, they widened the remit to include inflation in gilts, and it was really that in particular that was helpful for pension funds given that they tend to be the largest holders of inflation linked gilts. Interestingly though, it was more a confidence than actual market dynamic point because the Bank of England had offered to buy up to about 90 billion of gilts, but only ended up buying around 20 billion of gilts in total, which really highlights how it was a crisis of confidence in the gilt market.

Raj Mody: Yes, and that came through at the time I think because it's easy in some ways to look back with calm retrospective as we sit here a few months on, but at the time, really unusually for the pensions industry, this story was in the media everyday, in fact stories were being updated during the day, fair to say not always accurately but perhaps that's a nature of real time developing situations. But it did seem to be, as you've quite rightly put it, more an issue of confidence, at least to begin with more than anything else, although because of that crisis of confidence, that can then actually affect real decision making and cause real consequences. So maybe let's just turn to that, what was the actual effect then on pension schemes? And I know it's difficult to generalise because different schemes would have affected differently, but just take us through some examples, what happened from your perspective.

Lauren Brady: Yes, of course. So the majority of defined benefit pension schemes now use liability driven investment, and that's a strategy which tries to reduce the volatility in their funding level. So, in essence they're putting the liabilities of the scheme, i.e. paying their pensioners, at the heart of their investment strategy. And what they aim to do is invest it in instruments that give them a similar interest rate and inflation linkage to that which is in their pension payments.

What schemes do through LDI is then use leverage to free up some capital so they can use those assets to get inflation rate exposure similar to their liabilities, but also free up capital to invest in other high quality securities that pay a premium over gilt. And that actually allows the schemes to improve their funding levels by generating some extra income as well as managing their liability volatility. And the reason that the gilt yield moves affected the pension schemes-, actually the first one is a positive, so the funding positions of most schemes would have improved where they weren't fully hedged. So if they, say, hedged 80% of their liability risks, then actually their liabilities would have fallen quicker than their assets and they would have ended up with a funding improvement.

The second one is what we saw the, sort of, spiralling of yields where that meant that pension schemes were required to post margin on their LDI exposures, and in order to meet those margin calls, all their collateral calls, they had to sell quite a lot of assets very quickly in order to meet those calls, which typically would have happened over weeks or months, but in this instance were happening within days. So normally it wouldn't have been an issue, there would be a buffer held in their LDI portfolio to cover those collateral calls, but the unprecedented size of the gilt movements seen at the end of September led to these much larger collateral calls. So schemes had to prioritise selling assets to meet those collateral calls, which then created further market pressure. And some commentators have labelled this an LDI crisis, or a leverage crisis, or even a solvency crisis, but it wasn't really any of those things. For some schemes, not all the schemes, it was just a short term liquidity crisis, where it wasn't that they weren't good for the money, it was just they couldn't get the case quickly enough from one area to another in order to meet those collateral calls due to speed and scale of the gilt price moves we saw.

Raj Mody: Right, so it was as much an issue of events happening thick and fast than it was anything fundamental I suppose, it was just the pace and rate at which events were developing. So I mentioned the House of Lords report earlier, and they have quite rightly I think explored the bigger philosophical, if you like, and macro-economic issues about whether pension schemes should be that fussed about interest rates in order to be worried about hedging them in that way. And certainly what you describe as leverage, you know, multiplying their exposure because they care that much about hedging their interest rates. That's all a topic around whether the so-called present value, today's value of the liabilities, is a relevant measure compared to, say, the cash flows of the pension scheme that it's got to pay out over time. So that is a live debate at the moment, but it doesn't take away from the fact that this is what schemes are doing, and still doing, and that may well change over the future but we are still in a world and an industry where schemes are quite focused on LDI. So let's just turn to yes what were the practical issues? Because I suspect that the challenges that go with LDI strategies haven't completely gone away, so how could you summarise what led this to fall down, and therefore we're going to turn into what are the issues that scheme trustees and sponsors still need to fix as they go into 2023?

Lauren Brady: Yes, so despite the collateral calls being across a number of schemes, we did see quite a lot of disparity in how well schemes manage this, and there were some governance aspects I guess that we really saw come through as part of that. One of them was where schemes weren't fully prepared, and they hadn't thought through a clear sight of how quickly each asset they hold could be sold in the order they needed to sell that top up collateral.

Also, some, sort of, misunderstandings around how liquid assets actually were. So, a fund that previously might of been considered very liquid because it was a weekly dealt, they may have realised that when you allow for notice periods and dealing dates and settlement periods, so the time between putting the order in to sell the asset and actually getting the cash out, ended up taking more than a week. Like two weeks, three weeks, and given they needed that cash within almost days, it was just not quick enough. The other thing was looking at making decisions at speed, so where schemes had existing governance structures which weren't quite up to scratch, that was often an issue. The schemes with the most streamlined governance and pre-agreed liquidity and collateral plans in place, that really helped them to act as quickly as they could. And then finally, information flow. So we saw some really great collaboration between consultants, managers and trustees.

Where you could get all those people on a call or in a room at the same time, where you could ensure that there was a good data flow from example the LDI manager on your collateral position to the consultant to advise the trustee and then regroup all together, that really helped people to obtain a clear picture very quickly as to what was going on and what exactly was needed of the trustees as well.

Raj Mody: Yes and that's worth saying actually that in the heat of that period, there were some shining examples of how to do what you might call governance. Good governance at speed really, really well. So there were a lot of success stories but I think it's fair to say there were also a lot of challenging situations. So Sam, what we've heard there, and it's quite wide ranging, right? We're hearing issues about, call it the complexity or the fit for purpose or otherwise nature of the asset portfolio, issues about how against that complex backdrop the relevant decision makers make their decisions and the speed at which they can make the decisions and also issues about data and information flow and to what extent everyone really understands what is going on. That feels like quite a lot to go for and a lot that needs re-invention frankly. So what's your perspective? I know you've been studying this quite closely over the last few months.

Sam Seadon: Yes, so I mean there are several themes that we think all push basically in the same direction towards less risk, less complexity and less cost in pension schemes going forward. I mean, I actually wrote about them in an article before Christmas 2022. The first one is that, the one you've already been talking about, which is that we believe that the funding level of pension schemes sponsored by UK corporates is actually quite a lot better than it was. PwC's own funding indices attest that. We've recently reported very healthy surpluses in our two funding indices which is the PwC low reliance index and the PwC buy-out index and that's obviously great news for sponsors but also for members and trustees.

Raj Mody: Yes and just to elaborate a bit on those indices, if listeners aren't familiar. So, the PwC buy-out index, starting with that first, that compares the assets and pension schemes to the theoretical cost of buying them all out. Buying out the pension commitments with an insurer and, amazingly, that shows an aggregate across the UK pension scheme universe that there is a surplus on that measure. Now, you know, you can have a view about the relevance we were talking about earlier of the single number, the present value of those liabilities and is that a relevant measure for you but if you're trying to transfer your liability with an insurance company, it is a relevant measure because that is the price. That is a premium you're paying, like it or not. So that shows there's a surplus on that measure, in aggregate at least, and the low reliance thing-, we won't go into detail now but essentially that's a comparable measure but assuming that you keep the pension scheme on the corporate balance sheet but manage it in a sufficiently low risk way that you're not expected the corporate to step in to bail you out.

But it's a good point you make that at least on those measures, you know, and the relevance of those measures varies according to your specific situation. Things are looking pretty rosy, right? So yes, carry on.

Sam Seadon: Yes and I mean it all suggests that the need for high asset returns and leveraged LDI is maybe relatively limited compared to before yields rose. That sort of started from the end of 2021 onwards. So we think that many schemes will be able to generate sufficient returns with relatively unlevered portfolios. Things like gilts, corporate bonds and maybe some more illiquid assets. I mean we suggest trustees and sponsors do review their strategy, their asset mix and so on but also their governance which is the tool that they use to deliver their investment strategy to that end. To the extent that higher returns are needed to fix the deficit, then understanding the liquidity of those assets is obviously going to be very important. Pension schemes that aren't planning to buy out have a long time horizon so some illiquidity is okay but you've just got to have a look at the liquidity of those assets and make sure you understand it. I do wonder if more liquid returns seeking assets could be a very collateral efficient approach now.

So, for example, public equity has done very well since 2009. Arguably driven a bit from quantitative easing and it's usually very liquid. It's also possible to integrate that into an LDI portfolio quite easily via physical equity, via equity derivatives which takes the pressure off somewhat, the LDI leverage, by doing it through the equity side. I mean you can also do weird and wonderful things about protecting downside and so forth with derivative so I think that's an interesting one to think about.

Raj Mody: Right but the point is that essentially other strategies are available, right? So you don't need to necessarily have LDI or certainly leveraged LDI to the extent that we've seen it-,

Sam Seadon: That's right.

Raj Mody: Yes, in pension scheme practice so far but having said that, let's just explore, are portfolios actually changing? What you described, is that theory or is that practice? Maybe I'll come to you, Lauren, first and ask the question, how are portfolios changing or how have they changed since October 2022? What are you focused on as someone inside a manager?

Lauren Brady: Yes, so, I think the point Sam mentioned, what we're seeing is certainly lower levels of leverage within LDI portfolios. I think for a lot of schemes, they probably can't quite afford to hedge what they want to without any leverage at all. As you might expect, given the market volatility, their collateral buffers have been reviewed. There's been obviously guidance from the Pensions Regulator and pooled funds regulators around maintaining a similar level of resilience to what they currently have and we've seen some guidance coming out saying around 3-4% of a collateral buffer should be what they're looking at. So we've seen schemes topping up their collateral pools to that level and looking at what they do, sort of, following that. Reviewing the liquidity profile of the assets outside the LDI portfolio, so ensuring that they've got that liquidity ladder in place where collateral pools do come in. Looking at establishing other ways of accessing either return or other assets. So as Sam alluded to, things like synthetic equity can be helpful where you have a, sort of, leveraged equity exposure through total return swaps for example.

You can also use, for example, things like corporate bonds where you've got a corporate bond mandate alongside your LDI portfolio. You can repo corporate bonds to free up some additional collateral while still retaining your credit exposure there. We've already touched on governance processes, so ensuring that your governance is as good as it can be if anything like that happens again. Finally, if you really want to keep your asset strategy the same and you don't have sufficient liquidity, looking at whether your hedge is the right size and shape within your LDI portfolio as well.

Raj Mody: Okay so loads of points there to go for. You have brought in to the mix, and I touched upon it in my intro, about the likely direction of travel when it comes to regulators. Sam, I'm going to give you this challenge. So not necessarily to second guess the final outcome when it comes to how we're going to see regulatory change effect pension schemes although I think as we sit here today it's highly likely that we will see some change, but you talked earlier about the sort of nature about how asset portfolios might change. You know less risky, less complex and so on and less costly. Say a bit more. Can you bring together the likely direction of travel with what might happen when it comes to regulatory direction?

Sam Seadon: Yes I mean from my perspective, and yes, as you say, I started before giving a list of the themes that we think are pushing portfolios in that direction of less risk, less complexity and less cost. So one was lower deficits that we've already talked a bit about. We also know that regulators are pushing for lower, more transparent investment fees and costs. So the FCA set up the cost transparency initiative in 2018 to ensure there was basically a standardised way for costs to be disclosed, so there's quite a lot of regulatory attention there.

Raj Mody: So that was happening anyway, well before these kind of issues?

Sam Seadon: Yes I mean lots of these are themes that were happening before that I feel like the LDI crisis has accelerated in some way. There's an agenda around scheme consolidation as well, being led by the regulator. So we know that's manifesting in commercial consolidators which is a specific thing and I mean it's had a bit of a slow start however we do see consolidation happening through the LDI and managers and through the fiduciary managers where a relatively small number of providers are responsible for the majority, the majority of the assets being managed. The funding code consultation is out at the moment and that's where the regulator is, sort of, indicating more prescription going forward about how schemes should eventually target to invest, what level of funding they should have when they reach their terminal portfolio. Basically the regulator is being more prescriptive on what you should do with your investments.

Raj Mody: And to be clear, that's the Pensions Regulator as distinct from the Financial Conduct Authority. So there's many regulators at play in this situation.

Sam Seadon: Yes. I mean since-, so that is the Pensions Regulator. It's interesting that the FCA separately to that, has also talked about regulation of investment consultants, recent select committees. That also came out in the Lords report that you mentioned this morning Raj. We'll see what happens, we'll see what happens there. I think they're not saying that that would have prevented the LDI crisis but it's interesting to see that it's been raised a couple of times from when it was previously raised back in 2016 or 17 I think. So we'll see what happens there. Also, the regulators are considering what the right amount of collateral and so on for LDI portfolios is. So there's interim guidance out at the moment that the Pensions Regulator has put out under some direction and guidance from the financial policy committee. We understand there's going to be further guidance to come. I think that's coming in the annual funding statement from the Pensions Regulator and also the Bank of England financial policy committee have said they are going to make an announcement in the next month or two as well. So we'll see what comes there.

So yes, for a lot of trustees and sponsors this might throw light onto their governance as Lauren has mentioned. They might want to consider, as I said before, an independent review of how the crisis specifically impacted them and consider whether future governance and scheme strategy are fit for purpose really.

Raj Mody: Well yes and that's what I want to try and move to now as we try and wrap up this conversation. It's that looking ahead. So we at PwC had been looking at the issue of gilt valuations and the gilts market back in, you know, 2020/2021. Well before the run up to that trend that Lauren described earlier in 2022. And seeing gilts gradually rise, we flagged that just something felt a bit at a kilter when it comes to the nature of that market. I want to try and do something similar now to the extent that it's possible and help listeners get ahead of what they need to be thinking about. So, you know, foresight instead of just hindsight. So I'll come to each of you. Lauren first, what should be on people's agenda? What should they be thinking ahead to to get ahead of, you know, and try and avert any future problems?

Lauren Brady: Yes, so, I think there's probably three areas, really, that we're focusing on with our clients to help them improve their resilience to things like this happening again. And they sort of fall into the buckets of liquidity, governance and integration which we've kind of touched on throughout all of this. So the first one, liquidity. Making sure that you're looking at your total collateral resilience of your portfolio, not just your LDI portfolio but your wider asset portfolio. Looking at where you source liquidity from, so for example, like Sam said, freeing up liquidity from elsewhere like synthesising equities or using corporate bond repo and then looking at steps to maintain that resilience as you continue to rise.

The second one, integration. So looking at centralising your collateral pool and credit assets. We're seeing increasing integration of mandates. So as Sam alluded to, where you've got an LDI manager having credit alongside it, and a sort of holistic risk management framework across all of those assets.

And then finally, governance. So, some of the points we've touched on like timely access to information, looking at the right reporting, having the right processes in place and potentially also looking at delegating some of those decision making capabilities within certain parameters. For example, managers being able to sell assets within certain parameters that you've set.

Raj Mody: Okay and then Sam, final thought from you. You and I talk quite a bit offline about the macro-economic and international picture. I mean I think that's a whole subject that could make another podcast so I'm going to try and ask you to do it in two or three sentences just now but you've got-, I know you've got thoughts about what is happening globally when it comes to the levers that affect supply and demand for UK gilts. Can you try and summarise that in a couple of sentences?

Sam Seadon: Yes I think the key point is, who is going to buy-, and you see this in the mainstream press. Who is going to buy all of the bonds that, say, the UK government and the US government are issuing? I mean there are basically three buyers. Institutions in the UK, the Bank of England and overseas central banks and one of the questions is whether overseas central banks will continue to be buyers of gilts because we know the Bank of England is unwinding its gilt programme. We know pension schemes have already bought a lot of gilts and so the question is going to be, who is going to buy the gilts as they come out? And that will obviously affect the price of gilts.

Raj Mody: Yes and as pension schemes do move over to insurance companies, to some extent they release some of those holdings of gilts so there's a lot going on in that market and I don't necessarily think it's just a one sided flow. It's very difficult to predict.

Sam Seadon: No, no. I think that's right. Yes, I think-, yes I think you're absolutely right. It is difficult to predict but yes, there's a lot of gilts coming to market and yes, the question is going to be, who is going to buy them?

Raj Mody: Brilliant, okay. Lauren, Sam, thank you both for joining me today to discuss this issue. I hope as you've been listening you've found it interesting and hopefully you found plenty to inform both an understanding of events to date but also ideas for what you should be thinking about for keeping future strategies up to date. Please do share this episode with relevant colleagues and friends who might find it of interest and we would be delighted to hear what you thought of it. Our contact details will be in the show notes so please feel free to get in touch and we will get back to you personally. In the same vein, if you have any specific topics you think we should be covering on future editions of PensionsCast, please let us know. And as ever, if you want to find out first when, as soon as, future episodes drop then please subscribe on Apple podcasts or Spotify. For now, thank you for listening to PensionsCast and good bye.

Participants

• Raj Mody
• Lauren Brady
• Sam Seadon