LDI – Feature
For instance, we own quite a lot of TIPS which give you infla- tion protection relative to US inflation, but it is a good proxy in some ways,” he says. As of March 2021, USS had 31% of its portfolio invested in index-linked bonds, compared to around 36% for a reference portfolio. But Keating argues that the volatility of linkers defeats the pur- pose of matching liabilities. “Inflation-linked gilts maturing in 2068 have had a volatility of more than 30% during the past five years. Just two days ago, the 2068 linker was at £137, now it is at £155,” Keating says, adding that this volatility makes them unsuitable as hedges.
Collateral crunch
Another challenge pension schemes are facing refers to their use of leverage. Any asset manager trying to sell trustees a strategy of investing exclusively in high-quality fixed income would have had a hard time over the past decade because net returns would be negative. But the appeal of LDI has always been the promise that trus- tees do not need to do that. A typical LDI strategy splits the portfolio into a return-seeking component and a liability- matching component. Not only would this allow schemes to book returns, but the liability-matching component of the port- folio would generally employ leverage through the use of swaps or repos. This would allow the scheme to offset substantial risks using only a small proportion of assets. These derivatives would be backed up by collateral which has been put down as a buffer if the strategy were to lose money. Smaller schemes would access such complex strategies through pooled LDI offerings and their collateral would also be pooled. All this worked brilliantly while interest rates were low with collateral pools growing significantly. But now that rates are rising, losses are being made and collateral pools are coming
under significant pressure, Keating says. “We have seen pretty much all assets fall by 20% to 30% – that means schemes will be getting collateral calls for 20% to 30% of their repo out- standing. We will be seeing forced selling of some assets to meet those calls,” he adds. Keating, a long-time critic of LDI, believes that the use of lever- age in this context is questionable from a legal point of view. “What is going on in liability-driven investment is illegal. “Most schemes are borrowing, and borrowing is simply not allowed for these purposes,” he adds. “Section 5 of the Pension Schemes Act is absolutely clear. Schemes might be using repos, which are a form of derivatives, and derivatives are allowed under Section 4 of the act.” In an article published by Keating, he argues that repo are a form of borrowing and should be considered illegal under the Pension Schemes Act. Keating says that trustees could even be in breach of their stat- utory restrictions on the use of derivatives and in some cases on their use of borrowing. The Pensions Regulator takes a different view. Whilst being aware of the use of leverage, it advises trustees to look out for any changes to the investment risks they expose themselves to. A spokesperson for TPR said that it was keeping an eye on a potential increase of leverage but as of late June, it had not seen any evidence of this across LDI portfolios. TPR also recommends that schemes that are having to increase leverage will put in place a liquidity waterfall structure for their collateral requirements with support from their advisers. The sharp rise in inflation combined with rising interest rates has put LDI strategies to the test. Fully-hedged schemes are now likely to incur significant losses. For Clissold, this does not mean LDI strategies are redundant. After all, the losses in a rising rate environment are now offset by a fall in liabilities and if rates fall again, they will continue to cushion the effects of rising liabilities. What matters is that overall, DB funding statuses have improved.
What is going on in liability-driven investment is illegal.
Con Keating, Brighton Rock
“DB schemes in the PPF universe are already in surplus now and many schemes are able to fully lock down risk,” he says. “LDI will continue to go from strength to strength.” Others, including Con Keating, remain critical. He believes that a focus on the present value of liabilities continues to be a distraction from a pension scheme’s fundamental role. “Hedg- ing the discount rate by buying gilts does nothing to improve the likelihood of paying pensions fully when due,” he says. Whatever the perspective on LDI, it is questionable whether every trustee that has signed up to such a strategy in times of falling interest rates expected to incur losses at the scale they are now. Trustee and investment committee meetings will see some uncomfortable conversations in the months ahead.
Issue 115 | July–August 2022 | portfolio institutional | 49
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