To understand how pooled LDI funds work, listen and watch this excellent video which explains the rewards and the risks of LDI pooled funds. Please watch it to understand the way that LDI works within a pooled fund.
Thought I’d share this great little video our investment team did in 2020 that explains the exact risk that materialised last week. https://t.co/RWuIVGzuzT
— Mark Rowlinson (@markjrowlinson) October 5, 2022
The risks of LDI pooled funds have been foreseen. What has not been foreseen is that the “recapitalisation processes” put in place by LDI pooled fund managers were not designed for the extreme market conditions that followed the mini-budget.
What is becoming clear is that the FCA and the Pensions Regulator over-estimated the resilience of pooled funds and/or underestimated the capacity of the market to increase yields unexpectedly.
Mel Stride, Chair of the Treasury Committee, has published the letter sent him on 5th October by Sir John Cunliffe, the Deputy Governor of the Bank of England , (whose task is to preserve financial stability).
It contains one paragraph which holds the key to how the crisis emerged and has so far been averted. It refers to “pooled LDI funds”. Pooled funds are offered not by banks but by fund managers using insurance wrappers – these managers include Schroders, BlackRock, LGIM and Insight.
Pooled funds have been described by Richard Lund as “tailored hedging for the masses“. Richard worked with Andrew Overend at XPS and both are now at First Actuarial.
By coincidence, I heard Richard Lund speak at the First Actuarial Conference yesterday and mighty glad he and his clients should be that Sir John Cunliffe took the action that he did.
“Had the Bank not intervened on Wednesday 28 September, a large number of pooled
LDI funds would have been left with negative net asset value and would have faced
shortfalls in the collateral posted to banking counterparties. DB pension fund
investments in those pooled LDI funds would be worth zero. If the LDI funds defaulted,
the large quantity of gilts held as collateral by the banks that had lent to these funds
would then potentially be sold on the market. This would amplify the stresses on the
financial system and further impair the gilt market, which would in turn have forced
other institutions to sell assets to raise liquidity and add to self-reinforcing falls in asset
prices. This would have resulted in even more severely disrupted core gilt market
functioning, which in turn may have led to an excessive and sudden tightening of
financing conditions for the real economy.”
The important thing to note in this paragraph is that though pooled funds were seen as the trigger, the loss to pension funds wasn’t the main reason for the intervention.
This appears to have been the knock on effects which could have led to the Government and industry’s financing costs shooting up because of the contagion in gilt selling. Not so much a run on the pound as a run on gilts.
It has been supposed that the intervention was to save pension funds, it now looks as if it was to stop instability in Britain’s financial system. The pooled funds had to be saved to avoid contagion, not to bail out pension schemes; bailing out pension schemes appears to have been an additional benefit of intervention.
“A sudden tightening of financing conditions for the real economy”
For the Bank of England, what goes on inside pension schemes is reckoned to be in a parallel “unreal” economy , an economy of abstract valuations which are tomorrow’s problems.
The economy in which Governments , corporations and ultimately private individuals borrow money , is impacted today and is therefore “real”.
It now seems that these pooled funds were a ticking time-bomb not just for pensions but for the “real economy” directly supervised by the Bank of England.
This suggests that those who regulate these funds (the FCA) and those who regulate their use (TPR) were managing risks the import of which went beyond their remit. That these risks had not been identified by the regulators of the Bank is a cause for general concern, not least to Mel Stride and the parliamentary Treasury Committee.
Returning to pooled funds John Cunliffe continues
The Bank’s operation is intended to give the affected LDI funds time to put their positions on a sustainable footing, increasing their resilience to future stresses.
There is not much of that time left. In one week, the Bank’s longstop will be taken away and if there is a further run on gilts, the LDI funds had better be prepared. Gilt yields are creeping up again.
The message at both First Actuarial’s conference and the parallel session run by LCP (with 600 people on the call) was that LDI funds had better reduce their hedging fast.
How was the wider import of an LDI implosion missed?
The explanations above will leave most of my readers perplexed at just why fund managers , advisers, fiduciary managers and regulators could not have seen this risk coming.
It’s well worth reading the enthusiastic endorsement of these funds at the point of sale including this remarkable pitch.
Schemes of less than £300m have never had it so good with regards to the number of risk reduction options available.
Small schemes were invited to consider LDI as a way of increasing the extent to which scheme assets and liabilities are likely to move in the same direction. This characteristic reduced the chance of a deficit arising or increasing, and risk was reduced as a result. LDI was theoretically a perfect pension product.
And LDI has worked perfectly, as DC lifestyling has worked perfectly- in the theoretical bubble. The trouble is they are working in the unreal world of pensions where a fund wiping out can be justified on the basis that it only happened because buying pension had become cheaper.
In the real world, the risks of yields shooting up , amplified sometimes five or six times by the use of swaps and synthetic gilts, was close to creating a disaster – not for pensions but for the economy. This is why statements that pension funds will come out of this crisis the stronger so miss the point.
It is not just the consumer who should be paying more attention to the pension , it is the institutions we regard as expert , who have some learning to do.
One thing’s for sure, if pooled funds aren’t ready for future shocks, the BOE is unlikely to bail them out again.
Postcript – LCP’s 1pm Wednesday call
Because of the clash, I wasn’t able to watch the LCP call on this same subject. I have seen it now, with my partner and we both think it excellent
Watch the webinar here: https://event.on24.com/
You can access the slides here
Equally disappointing has been the (predictable) reaction and the repudiation by TPR and those selling LDI against those “naesayers” who dared to question the sense and efficacy of leveraged LDI. I suspect, sadly, they peddlers will find a way to keep selling this though – £3tn of private sector DB is too big of a tempting spitting roast, and the alternative of actually investing in “growth” assets (supporting the economy) is too hard.
Also, it’s not an “unreal” world of pensions – it’s “selfish” and shortsighted for a sector of the demographic (DB has an elder age bias) to hypothecate so much value into low risk, low return assets. It’s plainly obviously that as a country we’d collectively have more likelihood of being to afford to look after people in their old age if more of that £3tn was invested in growth. It’s also hopefully clearer now that LDI is not without risk – do you really feel comfortable with the majority of your DB pension dependent on UK govt debt, which at any time can be one change of Govt away from default?
Who would have thought a conservative chancellor could trigger such a potential black swan event.
I have read and watched many LDI presentations over the years and have never seen one aspect of LDI Pooled Funds explained by actuarial consultants or fund managers. As the Bank of England letter makes clear: LDI funds themselves are typically based outside the UK. Perhaps the question trustees should ask is what regulatory advantage is being sought by this choice of domicile. Perhaps the consultants and managers should be required to offer an explanation prominently in their marketing materials.
May I start by thanking all recent contributors to the LDI debate? I however think the unrecognised cause and the bigger issue is quantitative easing (QE). QE was, and is, the key free market disrupting event, totally eclipsing the recent BoE intervention with world politicians and “independent” central bankers printing trillions of $, €, Yen & £s and not unwinding it. Quantitative Tapering (QT) still to be tackled and predictions and risk warnings are invited! Meantime most private sector DB pension schemes will remain focused on LDI dependent deficit management.
That’s certainly what the LCP seminar suggested – albeit the gearing of the LDI portfolios will be dialled down.