LDI – Cover story
during the past 15 years, making it possible to book higher returns from fixed income investments, without the need to use leverage. Simultaneously, higher gilt yields have massively lowered DB liabilities. By the end of September, schemes in the PPF uni- verse collectively sat on a £374.5bn surplus. The present value of DB liabilities is a little more than £1trn, compared to £1.7trn a year earlier. This dramatically reduces the pressure on LDI strategies to produce outsized returns and, therefore, the need for leverage. But it is important to note that this marks a big change in per- spective. Just last year, more than a third of DB schemes planned to increase their interest and inflation hedges, accord- ing to Mercer.
Another factor is that most DB schemes are now closed and that more than 80% of plans are cashflow negative, a figure that is set to rise to 98% during the next 10 years, according to Mercer. The changing life cycle of DB schemes could support a trend towards simplicity, Ian McKinlay says. “Through time you should be able to reduce the level of lev- erage because what happens is that you get shorter-dated lia- bilities which are easier to hedge with physical assets. With any LDI strategy, there is a tension to be resolved between how much the scheme hedges and how much return it needs,” he says. Regardless of which path they choose, the liquidity crisis in the gilt market will leave a lasting mark on DB scheme’s invest- ment strategy. They will now be even less likely than before to invest in illiquid assets such as infrastructure. Fixed income will remain the weapon of choice as they approach the end- game even more rapidly than previously anticipated, predicts DWS’ Bagwan. But there are also important macro-economic factors which will continue to present a challenge to LDI strategies. Perhaps the most important challenge is the beginning of a period of oversaturation in the gilt market. During the next 12 months, the Bank of England intends to sell £80bn worth of sovereign debt whilst the government plans for a surge in issuance to the tune of at least £200bn. Added to that is HM Revenue & Customs indemnity of the Bank of England’s asset purchase facility. This means that losses as a result of the Bank’s gilt sales would be covered, resulting in further gilt issuance. To this perfect storm comes the fact that DB demand for gov- ernment bonds is now largely saturated. With most schemes closed and taking steps to reduce leverage, it is unlikely that they will snap up the hundreds of billions of pounds worth of new debt that looks set to enter the market next year alone. While rising gilt yields bode well for measuring the present value of DB liabilities, the troubles in the gilt market are far
from over and will continue to put pressure on LDI hedges. More importantly, a further surge in bond yields could be dis- astrous for the broader UK economy.
Difficult questions
While the future of LDI is uncertain, difficult questions remain to be answered. For example, to what extent has the emergence of LDI and the focus on the present value of liabilities contrib- uted to premature de-risking, and in turn to the premature clo- sure of DB schemes? Could some schemes have fared better and stayed open for longer if they had simply invested in a broader array of growth assets? Should there be accountability for the losses that schemes will have booked from forced asset sales to meet collateral calls?
There are also difficult questions for the regulator to answer. For example, was it wise to encourage the use of leverage and complex derivative strategies when the Bank of England’s 2018 Financial Stability Report had already warned that the use of leverage through derivatives by pension funds and insurers could pose “a systemic risk”?
These questions could inform the DWP DB funding consulta- tion. The jury is out on whether LDI remains the most effective form of managing swings in interest and inflation risks.
With any LDI strategy, there is a tension to be resolved between how much the scheme hedges and how much return it needs.
Ian McKinlay, formerly of Lloyds Bank Pension Schemes
Issue 118 | November 2022 | portfolio institutional | 23
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