Since the end of September articles about liability-driven investment (LDI) have gone from the inside pages of specialist pension magazines to the front pages of the national newspapers.
Rapidly rising gilt yields sparked by the government’s mini-fiscal event created a cascade which resulted in the Bank of England intervening in long-dated gilt markets to prevent greater catastrophe.
This is the first in a series of three blog posts which will explain what LDI is, why pension schemes use, what went wrong and what could happen next.
Squaring the circle
To understand why schemes used LDI, you need to understand how private sector defined benefit schemes went from being an excellent recruiting tool for companies to a volatile item on the balance sheet. Luckily for you, I’ve done that in these three blog posts.
As explained in the last of these posts, changes to accountancy rules which meant pension scheme liabilities – the future benefits paid to scheme members – were now valued like a bond. That created problems for a finance director.
If a pension scheme was heavily invested in, for example, equities then this could create a mismatch between how the assets and liabilities of the scheme were valued. That created volatility in the balance sheet and finance directors loathe the value of items in their balance sheets changing unpredictably.
The best way to get around this issue is to invest all the assets into bonds so the valuation of the assets and the liabilities are more closely aligned. The Boots Pension Scheme did exactly this in the autumn of 2001.
But for most pension schemes this was not an option as there was too great a gap in the value of the assets and the liabilities. What was needed was a way to reduce the volatility of the valuation of the pension scheme without investing the whole portfolio in bonds. Liability-driven investment was the way to square this circle.
Liability-driven investment allows schemes to invest in the growth assets they need to close the funding gap while reducing the impact of interest rates on the liabilities. This is achieved by assigning a portion of a portfolio to an LDI fund. Rather than this fund just holding gilts, it holds a mixture of gilts and gilt repos.
A gilt repo is re-purchase agreement. The LDI manager sells a gilt to a counterparty bank while arranging to buy back that gilt at a later date for an agreed price. This gilt repurchase agreement provides cash to the pension scheme which it can then use to invest in other assets.
This mixture of gilts and gilt repos in an LDI fund uses leverage to provide capital to the pension fund. It is akin to using a mortgage to buy a house. Different levels of leverage were available in the funds – the more leverage, the greater the ratio of gilt repos to gilts in a fund.
The more leverage in a fund, the less capital a pension scheme had to lock up in government debt and the more it could use to invest in assets which could help to close its funding gap. This was helpful when interest rates were low but became problematic when gilt yields rose.
Low interest rates turbo charge LDI take-up
The low interest rate environment created by quantitative easing boosted the popularity of LDI strategies for pension schemes. The long-term nature of a DB pension scheme’s liabilities means they are highly sensitive to small fluctuations in interest rates.
As interest rates tumbled in the aftermath of the financial crisis, the value of the pension liabilities sitting on a company’s balance sheet ballooned. The sponsor company would have to keep in shoveling cash to try to stop the mismatch between the scheme’s assets and liabilities from becoming ever larger.
In these circumstances, it became imperative to get the volatility of the pension schemes liabilities under control to prevent companies from bleeding cash. Once the value of the liabilities had stabilised, it would be possible to focus on narrowing the funding gap.
It worked. According to LCP, by the start of this year schemes hedging of liabilities was around 85% and the funding gap had also improved. But at the start of the year, rising interest rates started to create problems for LDI strategies which was turbo-charged by the government’s mini-fiscal event. The next post will explain what went wrong.