The gilt crisis that brought down a UK prime minister also pummeled pension schemes and dialed up the heat on liability-driven investing. But LDI can still provide many benefits to pension plans – and US corporate plans may be particularly well positioned.
- In the UK, unexpected tax cuts slammed over-leveraged LDI strategies, creating a negative feedback loop between collateral valuation and derivative mark-to-markets — and putting the BoE under intense pressure to tame the gilt rout.
- The US and UK pension markets are fundamentally different in three key ways: structural differences, relative size and the use of leverage.
- Now is a particularly good time for LDI in the US: With long-end rates high and credit spreads wide, sponsors can take advantage of opportunities to buy cheap bonds to match their liability-duration needs, supplementing them with derivatives to efficiently hedge interest rate risk.
LDI gets its moment in the sun — for the wrong reasons
Hard times for LDI in the UK, but it’s different in the US
The UK bond market’s recent crisis was a wake-up call for the UK pension plan industry, which was whipsawed by market moves that sent gilt yields soaring and falling. The worst pain was felt by pension schemes that invest in LDI leveraged pooled funds or use significant leverage themselves. These approaches will no doubt get plenty of scrutiny from UK regulators, who are concerned that it’s a fundamentally flawed way for plans with limited fixed income assets to hedge interest rate risk. But for reasons we’ll explain, the same situation seems very unlikely to happen here in the US — and we believe now is a great time for LDI.
What happened to UK pension plans in recent weeks
On September 23, Kwasi Kwarteng — the then-chancellor of the exchequer for Liz Truss, the UK’s prime minister at the time — unexpectedly announced tax cuts for the wealthy. Investors balked at the idea of financing those cuts, deciding instead to sell UK gilts. Unfortunately for UK pension schemes with derivative positions, this was too much to bear, resulting in many sponsors selling gilts to cover their collateral calls and further accelerating the rise in rates.
This created a “doom loop”: Rates rose higher, more collateral was called, gilts sold off more, prices fell further and rates rose even higher (see Exhibit 1). You can see it in the numbers: The 30-year UK gilt yielded 3.77% on September 22 and 5.00% on September 27. On the brink of collapse, the Bank of England put in a “circuit breaker” of surgical quantitative easing on September 28 that flew in the face of recent tightening and rate hikes. The BoE promised a buyback of £65 billion worth of long-dated gilts to prop up rates. The yield on the 30-year gilt dropped to 3.93% by market close on September 28.
It’s important to remember that when rates are higher, liabilities are lower and funded status improves – all else equal. This was the case recently with UK plans that did not rely on leverage, highlighting the fact that for pension schemes, this was a liquidity problem, not a solvency problem. In fact, for these well-managed plans, the BoE’s intervention — which immediately caused rates to drop 100 basis points — actually limited their ability to lock in their improved funded positions.
A wild and confounding four weeks ensued, with liquidation of assets to cover collateral calls and unprecedented 100 bp swings (by October 14, the 30-year gilt was back to 5%). On top of that, yields on the 10-year inflation-linked gilt rose the most in 30 years. This all culminated with Kwasi Kwarteng’s removal as chancellor after only 38 days and Liz Truss resigning as prime minister after 45 days — a spectacularly volatile and unprecedented chain of events.
As of 10/31/22. Source: Bloomberg, Financial Times.
Three reasons why this is unlikely to happen to US corporate plans
As the crisis unfolded, the question on many US plan sponsors’ minds is “can it happen here?” We think this possibility is extremely unlikely for three reasons: structural differences, relative size and the use of leverage. Let’s look at each of these in order.
1. Structural differences: UK schemes use more government bonds than US plans
UK schemes are required to discount their cash flows with gilts plus a spread. In essence, this amounts to a liability measure that is akin to a risk-free rate plus about 50 to 100 bp. The result is that gilts are more widely used in UK plans than Treasuries are in US corporate plans.
Another factor to consider is that since the 1990s, UK pension schemes have been required to provide cost-of-living increases to their participants, unlike most US corporate plans. The result is a much more complicated pension promise, with an average duration of 20 years in the UK vs. 12 years in the US. This results in a greater allocation to index-linked gilts.
2. Relative size: UK pensions are a huge part of the UK economy, unlike in the US
Further compounding the matter is the proportion of all UK pension schemes’ liabilities to the size of the economy. As shown in Exhibit 2, UK schemes make up a far greater portion of the UK economy than their US counterparts. This tightly intertwined relationship makes UK plans vulnerable to exogenous market shocks, such the recent sell-off in response to tax cuts — plus the UK doesn’t even have enough gilts outstanding to cover all the liabilities. But in the US, there is ample capacity to invest and de-risk pension promises. Moreover, US corporate plans are less beholden to government bond allocations, allowing substantial investment in corporate credit.
As of 12/31/21. Source: World Economic Outlook, International Monetary Fund, SIFMA, Statista, Office of National Statistics (ONS) – Financial Survey of Pension Schemes (FSPS), DOL Private Pension Plan Bulletin.
3. Use of leverage: Much higher in the UK vs. US
As a result of the narrow bond market in the UK, pension schemes — aided by their advisors and trustees — have increasingly turned to derivatives, sometimes in direct collaboration with their fixed income managers. At other times, schemes use LDI leveraged pooled funds specifically designed to provide leverage on gilts and inflation linked gilts. For example, a sponsor could invest in a pooled fund with £25 million as collateral, which is “levered up” to achieve the duration exposure as if it were £100 million. This is not about holding physical bonds to meet duration targets, which sponsors do outside of the pooled funds as well, but to achieve the duration needed to match liabilities on margin. As rates declined over the last decade, many pension schemes re-struck their hedges lower, releasing funds for higher-yielding opportunities, but leaving the schemes more exposed to collateral exhaustion. But when rates rise suddenly, more money is needed to post collateral and not erode the duration needs of the derivative positions. LDI leveraged pooled funds are built to absorb some rate rises before they call investors for capital replenishment, but the recent swift rise in rates made that impossible. As a result, all sorts of fire sales were held in the UK — from gilts to CLOs and other asset classes — to cover LDI collateral calls.
There is a good deal of discussion taking place in the UK around what measures can be implemented to prevent this situation from recurring. Increased regulations are one option. Another is to have sponsors group together their physical assets and derivative mandates with one manager to easily meet collateral calls should the need arise.
The irony is that the funded status of UK schemes improved during October, moving up by 1% to 103%, on average, with surplus growth of £13 billion. This highlights how the liquidity crunch for many sponsors was not so pervasive as to erode solvency. In fact, on the whole, solvency was improved.
In contrast, US sponsors don’t use as much leverage as their UK counterparts. In 2019, the UK Pension Regulator found that one-third of the 7,800 UK schemes that responded to a survey indicated an average leverage of 4x, with some schemes having leverage as high as 7x. In the US, leverage is between 1x and 2x, according to industry insiders.
More reasons for US corporate pension plans to be reassured
For starters, LDI leveraged pooled funds don’t exist in the US
There are a host of other reasons — in addition to the three outlined above — why we don’t see the same threats to the US corporate pension landscape:
- LDI leveraged pooled funds simply do not exist in the US. They aren’t needed, nor are they wanted.
- Inflation-based benefits are required for UK pension schemes. But in the US, they are implemented at the sponsor’s discretion, and as a result they are quite rare.
- The UK economy has been facing serious headwinds, arguably starting with Brexit and culminating in the Truss government’s missteps. In contrast, the US economy is much stronger.
- The UK media has disingenuously conflated leverage with LDI. Liability-driven investing is not leverage-driven investing. LDI without leverage is an incredibly capable solution for duration-matching the liability promised by a plan sponsor. And in underfunded plans, a modest amount of leverage can inoculate interest rate risk, the second-greatest risk to pensions after equity risk.
We believe now is a great time for LDI in the US
Leverage and LDI do work well together when done in an appropriately risk-measured manner. Here in the US, sponsors, advisors and investment managers know the difference between leverage and liabilities, and they diligently stress-test their leverage positions to ensure an adequate foundation of physical fixed income assets in a portfolio. In light of the UK LDI crisis, many have found that even with rate movements that amount to three or four standard deviations, there is little threat to US corporate pension plans.
Moreover, this seems like a particular good time for liability driven investing. Long-end rates are up, but not quite at historical highs. And with credit spreads wide, pensions can get the credit yield and rate hedge in one package as well as meet their expected return on assets (ERoA) bogeys. Coupled with derivatives in thoughtful risk-prudent manner, sponsors can to leg-in to positions during market volatility and hedge interest rate risk while allowing for the optimization of their growth seeking portfolios.