Cover story – LDI
These cashflows suggest that many schemes have no intention to give up on their LDI strategy but are trying to raise additional cash to secure their hedges. Schemes are now being left with two options, says Calum Mac- kenzie, an investment partner at Aon. “They can either run with a reduced hedge or top up their collateral to maintain the hedge they have and that is going to be complex. It depends on the sponsor, it depends on their cashflows and how close there are to buyout,” he says.
It has been a busy couple of weeks for investors but also for trustees and consultants who are focussed on damage control, says Jessie Wilson, a professional trustee at Dalriada Trustees. “Over the last weeks, we’ve been working with our consultants across all schemes at Dalriada to ascertain what their LDI posi- tion is.
“Do we need to be doing anything right now in case volatility returns? That’s not a long-term strategy. You don’t try making that in the eye of the storm. It is about risk-reduction,” she adds.
Schemes that have been in pooled LDI strategies have been more in the firing line because they were less able to respond to short-term market challenges. But Wilson is keen to stress that risk assessments should avoid generalisations and that bigger schemes are not always run more prudently than smaller ones. “This is more about a combination of funding level, hedge level and liquid collateral availability that will be key, rather than specifically size of scheme,” she says. Wilson’s recommendation is that schemes without sufficient liquid collateral, especially pooled LDI schemes, should reduce their hedging because they cannot control the leverage levels in pooled funds. “Schemes that have to reduce hedging should be doing it in a thoughtful way, with regard to the long-term objec- tive of the scheme rather than simply running out of collateral and being forced out of hedged positions held,” she says. This sounds good in theory. In practice, it is hard to imagine that schemes have not been forced into rushed asset sales with little opportunity to consider the long-term funding objective. At the time of writing, it is too early to assess the damage that these sales have done to schemes’ asset valuations. The PPF index for November will provide some important insights.
Long live LDI
While the long-term impact of the LDI crisis on DB schemes is difficult to assess, the stage they are at in their lifecycle and the macro-economic context provide some indications of what the future of LDI could look like.
There is a scenario to envisage in which LDI could survive, albeit in a much more simplified form, much closer to how it was when first implemented, predicts Shalin Bagwan, head of pensions strategy at DWS.
22 | portfolio institutional | November 2022 | Issue 118
The amount of cash collateral that was drawn from us in the nine months between January and mid- September was exactly the same as was drawn in the two days prior to the mini- budget and two days after.
Barry Kenneth, Pension Protection Fund
This view is shared by John Ralfe, a pensions consultant and former head of corporate finance at the Boots Pension Scheme, who was at the helm of the scheme’s shift into fixed income in 2001.
“There is a world of a difference between LDI and leveraged LDI. The problems we are seeing now all have to do with lever- aged LDI. But it’s important not to throw the baby out with the bath water,” he says, predicting that schemes will retain their LDI strategies, but with reduced leverage.
Indeed, this appears to be the direction of travel for many schemes. While the first response to the crisis is to build up additional liquidity reserves, the longer-term strategy appears to be reducing the gearing and complexity of such strategies to cut the risk of further collateral calls.
And there are several trends which could support this process. First, interest rates are now much higher than they have been
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