LDI has eaten money.

This morning I will be giving evidence to the Work and Pensions Committee as part of its inquiry into Defined Benefit Pension Schemes with Liability Driven Investments. I will be giving evidence with John Ralfe, Con Keating and Iain Clacher who jointly and severally know a lot more than me about the mechanics and impact of LDI on these schemes.

My particular interest is in the impact that LDI has had on employers and on savers in DC workplace pensions whose interests have not been much considered in this debate.

I will be making the point that the use of leveraged LDI which was seen as a blessing to employers, has infact stored up problems which have now broken on employers in a black swan event that nobody apparently envisaged. That event will hurt many employers hard and limit their capacity to pay proper funding rates into DC (and a lot more besides).

How did LDI help?

The point of the LDI we are discussing has been to allow DB schemes to invest to cover (hedge) their liabilities while retaining some scope to invest in growth assets giving employers some relief from simply investing in fixed interest securities. We know the cost of covering a scheme’s liabilities by using gilts as the Bank of England do this in their pension scheme, it was for the BOE last year £129m , thought to be over 50% of the membership payroll ( 2016 estimates from Baroness Altmann). (2021 estimates from the Times).

Although the bank uses a little leverage (through L&G) ,

it’s funding rate is so high because that leverage is very low

The majority of the scheme is invested in actual bonds, not synthetics (derivatives).

But this version of LDI (one very similar to the original strategy created by John Ralfe at Boots) is simply too expensive for most employers who cannot fund their pension scheme at over 50% of member’s payroll.

By using the higher leveraged version of LDI, employer costs were brought down from these eye-watering levels. The use of such high levels of bonds has however meant that the liabilities (value in line with scheme assets) have been discounted at close to the gilt rate. That has meant employers have had to shovel extra (deficit) contributions into the scheme (albeit at a lower rate than the BOE).

Throughout the last twelve years of quantitative easing, employers have had to pile money into their DB pension schemes, leaving precious little for the funding of DC plans (for the majority of active employees).

Very few employers have the financial strength of the Bank of England so most employers have welcomed leveraged LDI as a means of keeping a check on the pension scheme’s volatility while limiting the cash calls to the P/L. This is what is deemed to be the “success” of LDI. But it has been a success bought at a high price in 2022.

You might like to think of the BOE as using a “not for profit” approach and of leveraged LDI using a “with profits” approach. The not for profits approach is hugely expensive but pays off the mortgage, the with-profits approach is cheaper but runs the risk of falling short.

Many employers are angry because they thought they had invested in risk reduction , only to find a black swan event has put all the risk they thought they’d paid to get rid of, back on their table.

All these bonds and gilts have now fallen in value.

Trustees were told to invest in low-risk assets by their regulator, and the use of LDI was not just condoned but appears to have been encouraged, to save outrageous demands on the employer. Bonds have seen their prices rise as QE has been extended but all that ended this year when the bond bull run emphatically ended.

The actual destruction in the aggregate value of DB pension schemes from falls in market values of bonds and gilts in 2022  is estimated by Keating and Clacher to be £500bn . This is because of their huge exposure to the bond markets, and to a great deal because of leveraged LDI.

Many gilts have been sold to meet margin calls from the banks and though pensions are now enjoying higher theoretical funding positions, their asset base has typically been depleted by around 20%. If the LDI programs stay in place, they are protected as gilt yields recede (as has already happened), but if the programs have been abandoned, there is no protection. We do not know how many schemes have lost their hedges, but – especially among smaller schemes in pooled funds, the suspicion is that many have. This leaves them standing naked when the tide goes out.

Even the schemes whose hedges have survived will be finding that their LDI portfolios demand more collateral and are likely to be reducing their leverage –  this will result in  more cash being needed to meet liquidity demands and to buy back gilts coverage.

The point is that while the schemes appear to be in good health in terms of funding, many are still a liability to their sponsors.

This will mean that many schemes will be having to go back to hard pressed employers over the coming years for more money. This is money that might have been spent on DC pensions. In short, LDI has not just hurt DB plans, it has hurt members of DC plans and employers who employ these members will have less to pay staff, invest for growth and less to manage their rising bills.

For schemes that didn’t adopt a bond-centric investment approach and have kept themselves clear of LDI, none of this applies. Whole sections of funded DB – including the LGPS, discount liabilities at much higher rates and are now looking very chipper. These are the schemes that have stayed “open” and have taken a long term view on funding.

Addendum for those who bought a non-guaranteed annuity in the past 15 years

It should also be noted (though this is now historic) that the LDI programs have created such demand for long dated gilts that the price of those gilts has been extremely high throughout the past ten years, as annuities are priced against long-dated gilt yields, that has made annuities very expensive too. Anyone who has bought an individual annuity in the period when LDI has been ascendant will have had smaller pensions because of LDI.