The past two weeks have seen significant amounts of time, energy, intellect, and ink spent analyzing what went wrong with liability-driven investment (LDI), and the ex-post rationalization of what was not a black swan event.
If one were to be standing in the City of London in around 1980 and said that 35 years hence interest rates would have been near zero, you would not have been classed as a visionary, that much is for sure. At that time to suggest that interest rates could go as low as even 5% would have seemed like quite a stretch.
Having missed this aspect of how economies evolve, there are some fundamentals of analysis (not modelling we hasten to add) that seem have simply not happened. Nobody asked the basic ‘what if?’ question, which in this case was ‘what would happen if interest rates increased beyond our baseline estimates or what if they spiked?’. It is this lack of critique and certainty in the sophistication of LDI as a risk management tool that got us into this mess.
We have written extensively elsewhere (see for example, here and here) that LDI does not manage the risk of the pension scheme and its ability to pay benefits as they fall due, rather it manages the variability in measurement of the present value of liabilities with reference to the yield on gilts, so we will not labour that point here, beyond stating that correction of the misconceived accounting standards will resolve the ‘problem’.
There is however, a more important point in relation to this. The forced and accelerated de-risking of pension schemes pushed pension funds into these ever more exotic products. Schemes with large exposures to LDI and leveraged LDI strategies, all received a clean bill of health from The Pensions Regulator (TPR). However, for every individual scheme that got past TPR, there are several questions that remain unanswered.
Having failed to do this, nobody asked the questions. What would happen if interest rates increased beyond our baseline estimates or what if they spiked? While this might fall into the domain of macro-prudential regulation, which TPR will argue is not their remit, it is impossible to manage the micro-risks at a scheme level without understanding the macro risks. Whatever way you cut this, there are serious questions to be asked of TPR.
Second, the standard line that we have seen is to push this onto trustees and their advisors. While there are serious questions and challenges to be asked of both, this is a wholly disingenuous approach as it implies that this was nothing to do with TPR, which is simply not true. There are many examples, big and small, of the regulator actively foisting these strategies onto pension funds. With a problem of this magnitude, there is more than enough blame to go around for the regulator to take their fair share.
What next for LDI?
The next few weeks are going to be interesting, in the ‘worrying in the extreme’ sense of being interesting. With the Bank of England intervening to support the orderly working of the gilt market, this has bought some time, but not a lot of time for trustees and their advisors to work out what next. However, trustees are going to be operating under huge uncertainty and with partial information at best. With news of significant calls being made of trustees to sell large amounts of what liquid assets they have, and Goldman Sachs among many others buying high quality assets at fire sale prices, this has a long way to go.
We are also seeing an emerging narrative of LDI being a good thing that worked until it didn’t, and so the narrative goes, LDI is in need of reform as opposed to being something that needs to be stopped. Arguments such as, ‘maybe leverage of 7x is too much’ or ‘better cash management is needed for margin calls’ etc.
As long-standing critics of LDI this seems rather odd to us. The argument that the bridge didn’t collapse for a decade despite a structural engineer saying it was going to collapse because it was built badly, does not make the engineer wrong for nine years and 364 days.
In the reframing of LDI that we are now seeing going on, the biggest tragedy will be an accounting of this at some point in the future that says ‘look it wasn’t as bad as everyone thought’ because of the shrinking of the present value of pension liabilities because of higher gilt yields.
This is to obscure the economic catastrophe that has been brought to bear on both DB and defined contribution pension schemes. There has been significant destruction capital through this process, capital that comes from member and employer contributions as well as tax relief from the Exchequer. Once this process has unwound, whether in an orderly or a disorderly manner, sadly, members and their benefits will be less secure as there will be less money in the pot to pay their pensions.
Iain Clacher is professor of pensions & finance and head of the Centre for Financial Technology and Innovation at the Leeds University Business School. Con Keating is head of research at Brighton Rock Group.
Well articulated summary of the problem. There is not a word of this that doesn’t make absolute sense. It partially goes to the” why” – TPR sought to manage schemes on a micro basis, without consideration of the whole (“not my job, gov”).
State pensions are paid by the State. Private (DB) pensions should be paid from a share or spoils of economy, and so encouraged to invest and support it. If nothing else its poor diversification to have diverted and invested so much private sector DB in the State (ie gilts).
The other part of the “why” was the belief system that pensioners’ income should have a prioritised allocation (ie a risk-free allocation) of the economic output, and hence the model needed to find a “risk-free” asset – which it decided was gilts. It has also suited various governments (I recall challenging a coalition minister of this) for so long to tap into pension schemes, like a blood tap into a highland cow feeding ancient crofters over the harsh winter months. But, eventually that tap becomes too burdensome for the schemes to bear, and the mis-allocation of capital into gilts/the State is now acting like a dead weight, the dead hand of the state. Leveraged LDI was an accelerator, dreamed up by the same spreadsheet wizzes that brought us LCTM in 1998, justified only by ignoring (and indeed on the Regulatory side, shutting down questions on) the inconvenient tail risk (the “what if” questions in the article).
The articles lays helpfully out the only real long term solution – the schemes are too big to be treated as a prioritised adjunct to the economy; they are and should be a fundamental source of long term capital and growth, and hopefully there are enough wise and chastened minds in the Treasury and TPR to influence the funding regulations in that direction. My fear is that the short-termism of careers, political and financial will prevail, and we’ll end up with more of the same for now. Hopefully not.