In the first 20 years of this century, DB pension schemes were told to “de-risk” by loading up on what was referred to as “risk-free” investments – long term and inflation linked gilts.
“Loading up” meant borrowing money to buy more gilts than the scheme could afford from its own resources, this borrowing was sanitised by the term “leverage”. The matching of liabilities with these gilts became known as Liability Driven Investment and the use of borrowing – “Leveraged LDI”.
While interest rates were artificially depressed by quantitative easing, Leveraged LDI was effective in stabilising scheme funding, but when the cork came out of the bottle in 2022, the value of gilts plummeted as inflation surged. The gilts no longer covered the borrowing and the banks called in the loans , requiring pension schemes to sell assets to meet “margin calls”.
Con Keating and Iain Clacher estimate that around £166bn was lost to the asset based of occupational DB pensions as a result. For a time the sell-off caused chaos in bond markets and led to the fall of Liz Truss’ Government.
For many pension schemes, the loss of assets could be brushed under the table, while the LDI crisis had made them forced sellers, often at way below market price, the increase in interest rates meant that the valuation of long term pension payments fell. Though there were less assets to pay the same pensions, marked to market accounting saw pension schemes swing from an overall deficit to surplus.
But the Bank of England has not accepted the chaos of September and October 2022 as crumbs swept under the table.
Ben Martin, banking editor of the Times, reports that the Bank has required the Pensions Regulator to scrutinise every defined benefit scheme in the country over their exposure to the controversial investment strategy as part of efforts to avoid a repeat of the fiasco.
Truss and Kwarteng’s 2022 budget not only lost pension schemes an estimated £166bn, it caused chaos to Government’s capacity to raise money. The government bond market was only stabilised when the Bank of England stepped in and spent £19.3 billion on emergency gilt purchases.
Kwasi Kwarteng and Liz Truss before it all went wrong
We learn from the Times that all 5,000 private sector defined benefit schemes and hybrid schemes in the UK were asked 23 questions about their use of leveraged liability driven investment funds (LDI) in a compulsory annual survey of the industry conducted by the Pensions Regulator this year.
The exercise, which has not previously been reported, is one of a series of initiatives by watchdogs to step up their oversight of this area,
Every occupational defined benefit scheme and hybrid fund, which are schemes that include DB elements, are required to submit a so-called scheme return to the Pensions Regulator annually. This return gathers information about the industry and was overhauled this year to include a section on leveraged LDIs.
Hopefully these returns will officially answer the question asked of me and colleagues in parliament by the work and pensions committee
“when do you think we will know the true cost of the crisis”.
If schemes used leveraged LDI, they were asked to disclose the asset manager providing the fund, whether it was pooled or segregated and the net asset value of the mandate. They were also asked a series of questions about their ability to meet margin calls. Submissions were due at the end of March.
John Ralfe told the Times that while data-gathering by the watchdog was welcome but added:
“You can have as much information as you want but what are you going to do with it?”
In March last year, the Prudential Regulation Authority urged the Pensions Regulator to toughen its oversight by ensuring that LDI funds had enough liquidity to withstand a jump in gilt yields of at least 2.5 percentage points. This prompted closer scrutiny of the industry by the pensions watchdog, which has been welcomed by the Bank.
Neil Bull, the pension regulator’s executive director of market oversight, told The Times:
“We recognise the important role that pensions play in the wider financial ecosystem. That is why we continue to monitor the potential risks presented by LDI and, as recognised by the Bank of England, have put in place measures which mean that any future stress event can be managed.”
Though the watchdog is wise after the event, the fact remains that it was at the very least complicit in the use of leveraged LDI in the two decades leading up to the crash.
Alternatives to Leveraged LDI were available , but most proved unacceptable to the Pensions Regulator. It would be wrong to exonerate TPR from blame over the leveraged LDI crisis but right to praise them for ensuring lessons from 2022 are properly learned.
Within the scheme of which I am a member – governed by Hewlett Packard Enterprise Trustee Ltd – there was a combined reduction in asset values of £1,596million across two DB schemes for Digital and HP employees. Each scheme went from a surplus to a deficit.
What I’ve always struggled with – is the many article and press references to schemes coming out of the LDI crisis with a surplus – and yet there were some that resulted in deficit. Those that went from surplus to deficit would suggest significant assets sold at a loss to meet their “margin calls” – and does this suggest over-hedging? Does it suggest Trustees maybe did not fully understand the strategy and risks their advisors were implementing on their behalf?
Interestingly, in 2022, the company granted a discretionary increase of 3% for pre-97 pensions – following 13 years of consecutive zero discretionary increases. This increase was fully funded by the surplus that existed in the fund at the time, after much pressure and appeals by the Hewlett Packard Pension Association to both company and Trustees to deal with the issue of consistent zero increases over the past 22 years. Within these schemes – only 3 discretionary increases have been granted over the past 22 years. The scheme has now returned to 100% funding level – but of course there were again no discretionary increases in 2023, and 2024. Members were hoping for better outcomes and discretionary increases in 2023 and 2024 – and it could be argued that LDI losses scuppered any chance of that.
Will be interesting to ask what answers our scheme gave to the TPR survey questions.
BofE in hypocrisy shocker. It’s catching.
Just what I could dig up quickly.
https://www.ftadviser.com/investments/2021/08/05/boe-warns-on-inflation-but-still-expects-it-to-be-transitory/
The BofE were just utterly wrong on inflation, it’s magnitude, and waiting far too long to cool things down.
Anyone with a professional duty, like a trustee with LDI, would have seen this risk approaching miles off had the BofE not been like a stumbling drunkard looking for a light switch in the dark.
Instead they talked down the risks of gilt values falling (transitory inflation), then suddenly went full throttle tightening, and ~ 6mo later that intersected with a market waking up to this not being transitory, and a government who shockingly wanted to borrow money to stimulate the economy, rather than tax it into growth like Labour are planning today.
Blame lay all around. But in a zirp/QE environment, non-leveraged gilts were basically throwing piles of money away vs global trackers.
It must be great working at the BofE, it seems you can muck it up again and again and then blame others for the mess you caused.
When ILGs were first issued in 1981, they were greeted with acclaim as enabling matching index-linked (RPI) benefit payments. In reality, they were nothing of the sort, even though UK actuaries and TPR retained that thought process. In order to secure inflation linked income (soon to be CPIH rather than RPI), one must buy a huge wedge of capital which noone really wants, making ILGs highly inefficient. As at 31 Dec 2023, the uprated income was equivalent to 0.53% of the uprated capital. Con and I show an example at https://www.ukrpi.com/who_wanted_ilgs.htm and I have a separate conventional gilts example, which I don’t know how to post here! Anyone who wants it can reach out to me on Linkedin (unless you know my email address).