Most felt concerned went they heard an obscure part of the pension universe almost blew up the UK’s financial system. The conclusion was the recent LDI shenanigans must have had a negative impact on closed private sector defined benefit pension schemes.

But, if you are lucky enough to have such a pension to provide you with an inflation-linked income until death in retirement, there is no need to worry. Your pension scheme remains solvent.

In fact, it might well be in better shape than it was a year ago. That’s because rising interest rates are positive for DB schemes.

As I explained in the first blog and in an earlier trio detailing the rise and fall of DB, the current value of pension scheme liabilities is assessed using bond yields as a discount rate. Low gilt yields increase the present value of future benefit payments while higher rates reduce them.

The recent increase in gilt yields has been beneficial in liability valuations. What really counts, however, is the funding gap between the value of the assets and its liabilities. The goal of a pension scheme is for its assets to have a higher value than its liabilities to ensure it can comfortably pay these future benefits.

The good news is asset values have held up well which has improved this funding gap. According to the Bank of England, more than 20% of UK DB pension funds were in deficit in August 2022 compared with more than 40% a year earlier.

It’s a black fly in your Chardonnay

As the dust settles in the aftermath of the LDI crisis, there is, as Alanis Morrisette once opined, plenty of irony to go round.

The first is the one already mentioned – that closed DB pension schemes are in pretty good shape despite LDI creating enough of a market catastrophe that the Bank of England had to intervene.

But it is the schemes which ignored the lure of LDI for all these years and kept their hedging levels very low or zero which are the biggest beneficiaries of the current macro-economic environment and will have seen the sharpest reductions in the present values of their liabilities.

Where are we?

Those pension schemes which used LDI to hedge their interest rate risk will now need to undertake a thorough strategy review. They will first want to assess their current hedging levels, the impact on their funding gap and the shape of their asset portfolio.

Schemes will need to assess how close they are to their final goals. That’s most likely an insurance buy-out – where the scheme is transferred to an insurance company. Self-sufficiency is another common goal – when the scheme has enough assets not to need cash top-ups from the sponsoring company.

Those schemes which find their funding position in good shape – including those which had very low levels of hedging – are likely to want to lock in those gains by selling risky assets and buying either low leverage LDI funds or bonds.

Many schemes may want to eschew LDI and revert instead to a simpler asset-liability matching (ALM) strategy of buying bonds and living with lower levels of interest rate hedging. Trustees are likely to be feeling fairly testy about their recent experiences of frequent margin calls.

Schemes are in a very different place then they were at the start of the millennium. With funding positions much improved and the return of a high inflation and interest-rate environment, a more traditional ALM approach may seem more appealing. And that could be difficult for LDI managers.

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