In a major article , labelled an FT “big read, Jo Cumbo and Jonathan Ely , examine the LDI crisis and try to establish how pension schemes will change the way they invest. In its central session it contains an interesting quote.
“In the aftermath of the LDI crisis the strategic asset allocation of DB schemes will change materially,” says Michael Eakins, chief investment officer at Phoenix Group, one of the UK’s largest savings and retirement businesses. “They will be less invested in private markets and more in liquid markets like bonds and gilts.”
Cumbo and Ely had concluded that this was a crisis of liquidity and not solvency and liquidity was required because of the cash calls of the banks that had leant to pension scheme to double, triple or quadruple up on their holdings of gilts. In the great sell-off to meet these cash calls, long dated gilts had plummeted in value not just because of distrust in Government’s capacity to repay debt (under Trussnomics) but because gilts were being sold back to the market to maintain “hedges” (eg artificial holdings of gilts).
It is quite right for the general public to question why, after all this, pension funds will want to invest more in “liquid markets like bonds and gilts”.
When do pension schemes need liquidity?
It is right to ask this simple question. The funded pension system need liquidity to pay pensions and it also needs liquidity to pay cash equivalent transfer values (CETVs).
Sadly the ONS has ceased to publish this data series but we know that the liquidity pension schemes had to generate to pay transfer values remained at over £30bn pa through to the abolition of conditional charging and the decline of free money in 2021.
The availability of cash in a DB scheme comes either from injections from members and sponsors or from dividends generated by assets, the calls on liquidity from CETVs and the payment of pensions was a major constraint on the investment of assets throughout most of the past decade and this is principally because of the discount rate by which liabilities are calculated , which is based on gilts.
So low gilt yields throughout the period of quantitative easing led to high transfer values as liabilities were artificially high , just as gilt yields were artificially low. Schemes were paying a high price to shed liabilities, as Trustees would tell me – “we are giving away our prudence to personal pensions”.
What is not spoken of , but which should be, is that schemes , had they linked their discount rate to the returns anticipated on scheme assets (including equities) would have offered much lower transfer values, had much less need for liquidity and could have avoided the need for LDI. But using equity returns as a means to discount liabilities was considered too risky by the Pensions Regulator, it was safe old – liquid old – gilts that ruled the roost.
The classic example of a scheme being required to desert an equity based funding policy with high discount rates and low transfer values for a gilts based funding policy with the opposite, is BSPS. When the British Steel Pension Scheme was required to abandon its lng-held growth based asset allocation in early 2017, its new discount rate meant CETVs doubled, this precipitated one of the great runs on a pension scheme seen in modern time with over £3bn being liquidated into transfer values in the “time to choose”.
Pension schemes sometimes need liquidity for the wrong reasons. We will look back at the filleting of pension schemes such as BSPS in the name of de-risking as one of many reasons pension schemes are hitting the buffers today
Once bitten, twice shyt – why do pension schemes want more gilts?
Despite the depletion of assets caused by LDI and the poor performance of gilt and bond portfolios this year, pension schemes now count themselves more solvent because their gilt based discount rates make them so . CETVs are half what they were in the period of quantitative easing and if pension schemes do not return to borrowing through derivatives, cash calls for CETVs will be low. Pensions will still need to be paid, but this can be done through the cashflow generated by redemptions and yield from growth assets.
So why the calls for more liquid, lower returning gilts and why not a return to the days when pension schemes bought and hold stakes in companies as long-term investors?
The answer is in the philosophy of “de-risking” which tells trustees that the only good pension scheme is a dead pension scheme , or at least a scheme which is under the lock and key of an insurance company.
Insurers are of course the main reason why pension schemes want to be liquid. They are not going to venture into private markets to pick up assets that cannot be sold when the insurance company comes to value the scheme for buy-out.
Indeed the vast majority of our corporate DB pension system is in “pre-pack” busying itself preparing for new owners. As the leverage from LDI is unwound. so will any remaining ambition amongst trustees to grow the assets of the scheme in the real economy, rather than through the means of shadow-banking introduced through LDI. Gilt funding will become pension scheme’s lingua franca. When in doubt buy gilts and if you can’t buy gilts , keep your money in cash.
So ends our great economic opportunity?
The letter from Sunak and Johnson to the trustees of corporate DB pension schemes, is only a year old. In that year we have seen most corporate DB schemes pack it in and prepare for buy-out,
But while the great pension schemes withdraw, retail investors have no choice but to invest in real assets. We read today that rather than investing in gilts, they are leaving gilt funds in droves. The Quliter Investors Gilt Index fund lost more than £500m between November 2021 and late October 2022, when investors were notified of its closure, according to Morningstar. The sum included redemptions of £257.6m in June and £124.3m in March. The fund will take no more investments after this week.
Understandably, private individuals have become fed up with being told that gilts are risk free when they can see the opposite is the case. The fund’s closure comes after a difficult year for UK bond fund managers, with the combination of ongoing inflation and rising interest rates eroding the value of gilts. The impact has been particularly harsh for longer-dated products: a 30-year gilt maturing in 2051 has lost more than 35% of its value in the year to date
Betting on the cost of Government borrowing is proving an expensive business and while the insurers and occupational schemes have to buy gilst, investors don’t need to hold them.
It would be good to think that private investors were themselves wishing to take long term investment decisions. But this is unlikely. Cumbo and Ely conclude their Big Read with this assessment
While DC schemes in theory have a long-term time horizon, they offer daily pricing to allow investors to transfer in and out of funds at will using up-to-date valuations for those assets. This could be hard to square with the government’s push to encourage more investment in inherently hard-to-sell assets, which are valued far less frequently.
Stephen Scholefield, senior partner at law firm Pinsent Masons, adds:
“Because of [the recent] experience I don’t think DC trustees will be rushing to go into any form of illiquid investments, even though this is what the government is encouraging.”
Others worry that political turbulence in the UK has become an obstacle. LGIM’s Laud says:
“If you want to attract private capital you have to provide certainty that the regulatory framework is not going to be subject to random change and reassure investors that economic considerations of these projects won’t be derailed by the political outlook.”
It is a tough call on a new Pensions Minister, but Laura Trott is going to have to find a way to encourage our pension system to invest in Britain’s future, she has been dealt a poor hand with which to do so.
Appendix – an investment consultant writes
For investment consultants with a degree of imagination and a keen grasp of jargon, here is an alternative take on the above from Aon’s supremo. Calum Mackenzie posted on linked in
Gilt crisis could reignite pension demand for equities and private markets – yes, really…
Having endured volatility exceeding that of Bitcoin and uncomfortable cash calls, pension funds will be looking at their asset strategy with new focus. Corporate sponsors will be keen for a seat in the room. The FT article below highlights some of the challenges, but could it be that initial thinking is being shrouded in the orthodoxy of the past 15-20 years? What if the recent gilt crisis is not the death knell for private markets commentators expect? With less leverage I have to make choices – make my assets sweat or hedge less of my liabilities.
What could possibly cause pension funds to choose to invest in illiquid assets after a liquidity crisis? Here are a few thoughts:
My gilts +1% portfolio can take quite a lot of leverage risk or a little bit of asset risk and get to the same outcome. Portfolio B may appeal to many:
* Portfolio A has 50% LDI (2x geared) + 50% Libor +2% “liquid” credit
* Portfolio B has 90% gilts / corps + 10% Impact Infrastructure (Libor +8%)
If I’m going to be illiquid lets be properly illiquid. In the gilt crisis “liquid” credit funds were of little use in meeting collateral calls. Some would rather know that assets are truly illiquid and earning an illiquidity premium (plus maybe making a positive impact to the economy / environment)
Partial buyins are less desirable? Maybe I should invest for a full buyout? Buyins are capital intensive and only reduce risk (normally) of shorter liabilities. If taking liquidity risk I want paid for it and I want a limited allocation.
A once in a generation buying opportunity – there are lots of pension funds looking to raise cash. If I can commit to a 5 year investment I may generate some outstanding returns via the secondary market (keep the head while others lose theirs?)
Sustainability – Many pension fund trustees, their corporate sponsors and their members want their assets to contribute to a more sutainable economy. The most impactful way of doing this will be through private markets. One asset owner told me that the big upheaval in portfolios removes one of the reasons to not make more environmentally impactful investment allocations. Worth considering against the backdrop of COP 27.
In many ways, this is an argument for a barbell portfolio. Much derided by modern portfolio theory and not a particularly nice result in a Value at Risk (VAR) model. Having said that, where reduced leverage does not allow pension funds to remove interest rate risk, have low asset risk and limit company contributions the solution may be one that needs compromise.
I would love thoughts and debate. Is there room for a barbell approach in new portfolio design? How will trustees and corporates view portfolios of the future? Lots of work to do but hopefully a constructive debate along the way.