De-risking – Feature
This was accelerated by the new government introducing price caps on energy and announcing other fiscal measures, which could lead to additional gilt issuance of £250bn during the next two years.
Yields on long-dated gilts have now been pushed to their high- est levels in 20 years, a trend which will again drive down the present value of DB liabilities and accelerate investment returns for schemes invested in UK long-dated bonds. But there are also counteracting factors, which critics of LDI strategies are keen to point out. One is that linkers, the primary tool DB schemes use for protection against inflation risk, prove to be costly in a rising rate environment. With the price of link- ers being inversely related to real yields and closely correlated to inflation expectations, an environment of rising rates and falling inflation expectations means that linkers are likely to incur significant losses. It is yet too early to assess how this has affected DB schemes with LDI strategies so far but Keating estimates that they would have incurred billions of losses as a result of the double whammy of rising rates and lower inflation expectations. LCP’s Mikulskis counters this criticism making the point that LDI has performed as expected this year. “Linkers have gone down but that goes back to the mirror image concept of any hedging strategy. The whole point of LDI was supposed to be to perform a mirror image of what liabilities are doing and it has done exactly that, though the moves have certainly been very fast,” he says.
But linkers aside, there are other challenges for LDI investors. One problem is that inflation is set to hit fixed income assets much harder than equities. And with UK inflation forecasts ranging from a conservative 13% by the Bank of England, to 22% according to Goldman Sachs, central bank rates are widely expected to exceed 4% by next year. But DB schemes that have already bought into linkers with a long maturity are now locked into duration risks.
Investors might also struggle with UK inflation rising at a much faster pace than in Europe and the US. This means that Tips – US inflation-linked debt – offer insufficient protection from UK price rises.
In the new funding regu- lations, the portfolios that everybody is going to be forced into are LDI portfolios, and that would be a disastrous mistake.
Con Keating, Brighton Rock Group
Other factors to consider are the volatility and liquidity risks that come with LDI strategies. One key element of such strate- gies is that the remaining interest rate, inflation and longevity risks would be hedged by derivatives, with the more secure bond assets used as collateral. This meant that many DB schemes have built up significant leverage. USS, for example, reports that more than half of its assets (56.4%) are matched against its liabilities, at a net leverage of 27.4%. If LDI strate- gies were entirely implemented through derivatives, the com- bined volume of collateral calls could be as high as £380bn, former Columbia Threadneedle fund manager Toby Nangle told The Financial Times. Such levels of leverage must be painful to navigate when bond markets are facing huge swings, resulting in large scale collat- eral calls on the liabilities they used to hedge their liabilities. Consultants and investment partners working with DB schemes have confirmed that these collateral calls are hitting schemes hard, with some, particularly those in pooled LDI strategies, forced to sell their growth assets to meet margin calls. Advocates of LDI strategies would counter this with the fact that the damages made to a scheme’s assets have been offset by the sharp fall in liabilities. Because the calculation of liabilities is so sensitive to the slightest upward movement in gilt yields, at this point few questions are being asked about losses on the asset side. Where proponents and advocates of LDI agree is that improve- ments in the funding status of DB schemes have dramatically accelerated the endgame for many final salary schemes. And this is why the debate on the DB Funding Code is so hard to resolve. It touches the core of the UK pensions provision. DB schemes are winding up faster than expected and while defined contribution (DC) schemes have expanded the reach of pen- sion provision, the actual retirement income they offer risks being insufficient to sustain people throughout retirement. Meanwhile, longevity continues to increase. This means that the responsibility of paying members benefits does not disappear, but it shifts from UK companies who spon- sor final salary schemes to insurers, consolidators and DC scheme providers.
Issue 117 | October 2022 | portfolio institutional | 45
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