Ed Wilson says liquidity is the new king – at least for now
After the turmoil of last week, we are all adapting to the realities of the new world for defined benefit pension schemes. There are challenges to be addressed; it is a relief that the Bank of England has provided some breathing space for schemes to act.
What actually happened last week?
Long-dated gilts suffered their largest single day fall in value in history. Pensions schemes, and specifically their liability-driven investment (LDI) strategies were placed under enormous strain, not directly because of the levels of yields, but the speed of their change.
The industry simply couldn't keep up. While there was speculation that pension schemes were close to becoming insolvent, this was the not the case. For the majority of schemes, funding levels have actually improved. What happened was a severe liquidity squeeze. Assets had to be sold to fund the capital required to support LDI strategies, with demand for collateral making yields rise still further in a self-fulfilling circle. This was a close call: had the Bank of England not intervened to provide market liquidity, this situation would have spiralled out of control.
What needs to happen this week?
Liquidity is the new king - at least for now. Pension schemes have been required to make large capital injections into their collateral buffers; for many, liquid capital is scarce or has completely run dry. In order to recapitalise and replenish these supplies, schemes are being forced to sell longer-term assets, which in a falling market, can be perilous.
Additionally, there is the risk market of sentiment falling again as the Bank of England's temporary intervention ceases on Friday 14 October, but the Bank appears alert to the risk of speculators acting against the market and should nuance its exit.
Even if yields remain around their current levels, the need for collateral is huge. LDI managers, reacting to the message to the industry to get your house in order are deleveraging - schemes will need significantly more collateral to support their hedges. If this is not possible, interest rate and inflation hedges will be reduced or removed. As winter approaches, this isn't the time to go out naked.
Finding a solution requires alternative thinking and quickly. Many trustees are acting with urgency to do as much as they can. Specifically, generating cash by realising their more liquid assets and, in some cases, drawing on support from their sponsoring company. Some are having to tactically scale back their hedges - liquidity trumping matching - to avoid an uncontrolled reduction.
While such actions can help address the immediate risk, they do not present a viable longer term funding position.
What needs to happen in the longer term?
In an ideal world, investment strategies should be revisited as many schemes will have a significantly improved funding position. The cash shortfalls of most UK pension schemes versus their long-term targets have more than halved, and in many cases largely disappeared. Although trustees will wish to lock in these gains, this requires liquid capital to reshape the portfolio, which for most schemes simply does not exist right now. Some creativity is needed and although each scheme will need a bespoke approach, there are key areas which every trustee should consider.
The first is improve governance. Whilst many trustees have been updating signatory requirements to allow moving supporting assets to their LDI manager, they will still need to speak with their fund managers and remove any blockages in the system.
Secondly, push to improve asset quality. The selling of equity assets (corporate and real estate) and junk bonds in open-ended funds and replacing them with gilts and high-quality credit is already happening and should continue.
Finally, move more of the LDI portfolio to be held as physical holdings of very long dated gilts and index-linked gilts; using duration to create some of the leverage rather than solely relying on derivatives.
While there is a lot that now needs to be done in a short space of time, taking action now, trustees can implement a plan to secure their members' benefits.
Ed Wilson is an investment partner at Isio
