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06/10/2024

Revisiting Liability Driven Investment: The Evolving Landscape Of UK Pension Funds Post-Crisis




Revisiting Liability Driven Investment: The Evolving Landscape Of UK Pension Funds Post-Crisis
Two years after the turmoil that shook Britain's £2 trillion ($2.7 trillion) pensions industry, the financial strategy that contributed to that chaos—Liability Driven Investment (LDI)—is witnessing a resurgence in popularity among pension funds. However, industry providers assert that this time, the approach is being implemented with an emphasis on risk management and caution.
 
The crisis in September 2022 was sparked by then-Prime Minister Liz Truss's controversial 'mini-budget,' which proposed unfunded tax cuts. This announcement rattled investors, leading to a significant sell-off of UK government bonds, known as gilts. The subsequent volatility had disastrous repercussions for many pension funds, which had heavily invested in these bonds while also employing leveraged financial instruments to hedge against rapid interest rate changes and inflation. This reliance on LDI strategies left them vulnerable when gilt prices fluctuated wildly.
 
As gilt prices plummeted, pension funds faced collateral calls on their LDI positions, forcing them to rapidly liquidate their most liquid assets to raise cash. The panic selling of UK government debt further exacerbated the market’s decline. The situation prompted the Bank of England to step in and purchase gilts to stabilize prices, highlighting the interconnectedness of the financial ecosystem and the critical importance of sound risk management in the pensions sector.
 
In the wake of this crisis, regulators have pushed for reforms aimed at minimizing leverage and increasing collateral requirements to avert a similar situation in the future. However, they have also acknowledged the essential role that hedging strategies play in protecting pension fund assets.
 
"LDI is as important as ever to pension schemes, if not more important as many schemes are looking to manage potential surpluses and reach their desired end game," said Adam Baker, a manager in BlackRock's LDI business. His remarks underscore a growing consensus among industry experts that, despite the challenges, LDI remains a critical tool for pension funds.
 
A New Approach to LDI
 
In response to the previous crisis, LDI providers have taken significant steps to enhance the safety and effectiveness of these strategies. These measures include reducing the levels of leverage used and increasing the proportion of liquid assets, such as corporate bonds, set aside as collateral. This shift aims to ensure that pension funds can easily access cash if faced with sudden market shocks.
 
While industry executives express confidence in these adjustments, they also recognize that the new approach is still largely untested. No financial system is immune to potential disruptions, and the evolving landscape of interest rates and economic conditions could still pose risks.
 
Four of the largest LDI providers—Legal & General, Insight Investment, Schroders, and Columbia Threadneedle—have reported increased adoption of hedging tools among pension funds. For instance, Legal & General Investment Management (LGIM) stated that its defined benefit pension scheme clients have raised their hedging ratios to 86-87% of their liabilities, marking an increase of up to seven percentage points over the last two years. LDI has emerged as the primary strategy employed by these clients.
 
In light of stricter regulatory scrutiny, LGIM has also enhanced the collateral available to withstand significant interest rate movements. Their pooled funds are now better positioned to handle rate fluctuations of 3 percentage points or more, compared to the 1.5 to 2 percentage points previously accounted for, providing a more robust buffer against potential market downturns.
 
"Many people call it LDI 2.0," said LGIM's Anne-Marie Morris, emphasizing the evolution of LDI strategies in light of past challenges.
 
Trends in the Pension Fund Sector
 
Insight Investment has similarly noted an uptick in hedging among its clients, while Schroders has reported greater use of LDI by both existing and new clients, although specific data was not provided. Meanwhile, XPS, a pensions consultancy, found that the proportion of LDI assets held across its clients had risen by 8 percentage points over the same two-year period.
 
The ability of pension funds to reduce their leverage in the wake of the crisis is noteworthy. With higher interest rates bolstering their funding positions, many pension funds have seen their liabilities diminish, allowing them to adopt a more balanced approach to risk.
 
Data from The Pensions Regulator (TPR) indicates that the value of leveraged LDI positions currently stands between £600 billion and £700 billion, which is approximately half the level seen in late 2021. This represents a reduced, yet still substantial exposure to potential market fluctuations.
 
"Defined benefit pension schemes are better funded than at any time in recent memory," said Neil Bull, TPR's executive director of market oversight, affirming the improved financial health of many pension schemes. He added that the TPR would continue to monitor potential LDI risks closely, ensuring that the industry learns from past mistakes.
 
A Cautious Optimism
 
As the UK pensions industry navigates the aftermath of its recent crisis, the resurgence of LDI strategies reflects a cautious optimism among pension fund managers. While the lessons of September 2022 remain fresh in memory, the ongoing adjustments to LDI approaches and heightened regulatory oversight signal a commitment to building a more resilient financial framework.
 
In conclusion, the evolving landscape of the UK pensions industry demonstrates a blend of tradition and innovation, as stakeholders strive to balance the necessity of hedging against risks with the imperative of responsible financial management. With continued vigilance and adaptation, the industry may emerge stronger, better equipped to withstand future shocks while safeguarding the interests of beneficiaries.
 
(Source:www.bbc.com) 

Christopher J. Mitchell

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