UK pensions: liability-driven investing backfires
As a history student, British Chancellor Kwasi Kwarteng will know the law of unintended consequences in politics. He is perhaps less familiar with Warren Buffett’s aphorism about derivatives that they are ticking time bombs. Kwarteng’s mini-budget sparked an unexpected, rapid and explosive reaction in the gilt market this week, in part because of the derivatives used by pension funds.
The problem is that some pension funds have spent so much time hedging against falling gilt yields, which inflate defined benefit liabilities, that any leverage used in their hedges may have been overlooked. . Sharp increases in gilt yields mean that pension funds have had to rush to make additional collateral payments on interest rate hedges, forcing additional gilt sales.
A low and falling interest rate environment has increased the present value of long-term pension plan liabilities, leading to funding shortfalls, which pension watchdogs frown upon. One means of protection, so-called liability-driven investment strategies, help pension funds match members’ long-term liabilities with assets. This could mean swaps where fixed interest payments are swapped for floating rate payments, bad news in the current environment.
Specialist providers of LDI strategies such as Legal and General and Schroders may well have extensive experience in assessing the risk of these strategies. Indeed, rising interest rates will always be a good thing for most defined benefit pension plans.
The problem is the rate at which rates have increased. Pension funds typically hold enough collateral to cover a 125 basis point rise in yields, thinks Simeon Willis of consultants XPS Pensions. Yields on 30-year gilts rose 95 basis points on Monday and Tuesday this week alone.
This is where Buffett’s ticking time bomb explodes. To supplement lost collateral – margin calls – riskier liquid assets such as stocks are sold first. If this pool depletes, funds would then sell gilt holdings, fueling a feedback cycle that pushes yields even higher. The sale could then spill over into illiquid real estate assets, at bargain prices.
The end of this cascade explains the Bank of England’s decision on Wednesday to intervene to buy gilts and cap yields.
Frayed nerves and itchy triggers magnify the effect of any bad news. The Chancellor should therefore act quickly to calm the markets as quickly as possible.