Natalie Winterfrost: Should anything cause pension schemes to start selling index-linked gilts, it’s easy to see how we might have another crisis
In the Society of Pension Professionals’ (SPP’s) latest column for Professional Pensions, the organisation’s investment committee chair takes a look at the causes of the LDI crisis and the other risk that is still in the system.
Liability-driven investment, or LDI, is a risk management approach well used by pension schemes for at least a decade. And for good reason.
How much money needs to be set aside now to meet future benefit payments is dictated by the rate of return one can expect on assets. The best indication of this is the long-term risk-free rate i.e. the gilt yield. While pension schemes may invest in a variety of assets for higher returns, over the long term the expected return should be the risk-free rate plus a risk premium. This means that, regardless of actual investments, pension schemes need to hold higher asset values to meet liabilities in times of low gilt yields, but they don't need such significant reserves when gilt yields are high.
Actuarial valuations use this logic and discount future expected cashflow on a so-called ‘gilts plus' basis. Accounting valuations use a similar approach, albeit referencing yields on corporate bonds. It is therefore natural to seek to ensure that when rates fall our reserves increase and accept that when rates rise we do not need as much money set aside - this is LDI and it acts like insurance; but without the long term costs usually associated with insurance.
At SPP's meetings, particularly the investment committee that I chair, the gilt crisis has caused a certain amount of debate, self-challenge and introspection among members. Rarely has pensions got such mainstream press coverage and for those of us that appreciate the need for increased pension savings for the future health and prosperity of our country, the damage done to the public perception of pensions was so disappointing.
The right approach?
So was LDI the right approach or has the industry done the wrong thing?
The consensus remains that hedging a very material funding risk is the right thing for a scheme to do. However, the pension industry does not want to face another week like the week starting 26 September.
After the mini budget that was criticised by the International Monetary Fund (IMF), gilt rates increased so dramatically that schemes found themselves unable to access collateral quickly enough to maintain their hedging. Unwinding of hedge positions started, the sales pressure pushed rates higher and forced further unwinding of hedges and the ‘death spiral' was underway.
We can point to two things that caused this. One was the level of leverage in the system. Pension schemes typically held very liquid collateral for rates moves of 1-2% and considered this conservative as rates didn't move by anything like this in the short term. We now know rates can move by that much in a matter of days; the industry was quick to rethink what prudent leverage levels are and make changes.
The problem that remains
However, there is another problem that remains, and this one has no quick fix. Back in 2012, as use of LDI was becoming widespread, the SPP published a paper, 2020 Vision. This paper called out that defined benefit liabilities amounted to 155% of the sterling investment-grade bond market and 274% of the long-dated bond market. Obviously, the maths doesn't really add up if pension schemes wanted to get exposure to sterling bonds to hedge even 70-80% of their liabilities.
The paper further noted that if 60% of the UK pension liabilities had an inflation link, this equated to c.400% of the long-dated inflation-linked bond market.
This problem has not gone away. Over the intervening decade the Debt Management Office (DMO) has reduced the proportion of its issuance in index-linked gilts and pension scheme demand drove real yields far below zero.
Pension schemes are the only asset owners with an interest in holding index-linked gilts at anything like current yields. This is a problem with no obvious solution. Should anything cause pension schemes to start selling index-linked gilts, it's easy to see how we might have another crisis.
There will be changes in demand for index-linked gilts, due to variability in how much pension liability is inflation linked and a shift of capital to insurance companies as schemes reach buyout. The SPP is currently working on Vision 2030, to explore these issues further.
Natalie Winterfrost is chair of the investment committee at the Society of Pension Professionals and director of LawDeb Pension Trustees
