How Britain’s Pension Scheme Hedge Turned Into A Trillion-Pound Gamble

It started out quite easy: British pension schemes were seeking a way to match their assets to future pension payments.

Schemes run for bookseller WHSmith and pharmacy Boots were early supporters in the 2000s of an investment strategy of selling stocks for bonds, to protect themselves from interest rate changes.

But fifteen years later, the strategy currently applied by almost two-thirds of pension schemes has ended up circling around financial derivatives rather than just bonds – injecting a significant amount of risk to schemes that is only now becoming evident as interest rates hike.

In the so-called LDI or liability-driven investment strategy that became widely used, pension schemes would use derivatives – contracts that obtain their value from one or more assets – to shield themselves from probable swings in interest rates. With a small amount of capital, they could achieve large exposures.

There is a disadvantage: if the derivative becomes unprofitable for the pension fund owing to fluctuations in underlying asset prices, for example, it can be called up for more money, sometimes at short notice.

None of this was significant for a long time and consultants projected in 2018 that the market would soon get to the “The Age of Peak LDI” – it was so popular that the pensions industry had no more assets to hedge.

LDI assets grew four-fold in a decade to 1.6 trillion pounds ($1.79 trillion) in 2021.

But the strategy slowly became riskier, according to interviews with consultants, pension scheme trustees, asset managers, and industry experts. Things started to unfold as Britain’s Sept. 23 “mini-budget” prompted a surge in UK government bond yields, driving pension funds to scramble to raise cash to shore up their LDI hedges.

Those derivatives came close to collapsing, pushing the Bank of England to pledge on Sept 28 to purchase bonds to ease the panic. The scale of the money employing the LDI strategy, and ever-higher borrowing through the derivatives, had deepened risks that seemed hidden during a decade of low-interest rates.

When rates started hiking in 2022 and warnings about risk got stronger, schemes were slow to react, according to those queried.

“I do not like the term (LDI) and never did, it has been hijacked by consultants and has morphed into what we are seeing now,” said John Ralfe, who in 2001 oversaw the 2.3 billion pound Boots Pension Fund’s shift into bonds. The fund didn’t bulk up on debt, he told Reuters.

Ralfe said:

“Pension schemes were doing disguised borrowing, it’s absolutely toxic. There was much greater risk in the financial system than anyone – including me – would have thought.”

WHSmith failed to respond to a request for comment on Thursday. Boots failed to respond to a request for comment on Friday.  Globally, investors are concerned about other financial products dependent on low interest rates, now that rates are hiking.

“The so-called LDI Crisis in the UK is just the symptom of a greater economic malaise,” said Nicolas J. Firzli, executive director of the World Pensions Council.

Riskier Bets

In the twenty years since Ralfe’s time at Boots, defined benefit pension schemes – which assures retirees a fixed amount of pension payments – have loaded up on LDI and derivatives, using them to borrow and invest in other assets.

If leverage in the LDI strategy was triple, for example, it implied the scheme only required to spend 3.3 million pounds for 10 million pounds of interest rate protection.

Instead of purchasing bonds to shield against dropping rates – a major determinant of a scheme’s funding position – a scheme could cover 75% of its assets, but only commit 25% of the money, using the remainder for other investments.

The rest of the money could be allocated to private credit, higher-yielding equities, or infrastructure.

The strategy was effective, and schemes’ funding deficits reduced because the hedges narrowed their exposure to falling interest rates. Lower interest rates call for pension schemes to hold more money now for future pension payments. This made regulators and companies happy.

Asset managers including BlackRock, Insight Investment, and Legal & General Investment Management offered LDI funds in a low-margin but large volume business. The FCA, which regulates LDI providers, refused to comment.

Consultants such as Mercer and Aon made LDI pitches to trustees, while The Pensions Regulator (TPR) – the government entity regulating pension funds – urged schemes to use liability matching to reduce deficits.

About two-thirds of Britain’s defined benefit pension schemes use LDI funds, according to TPR. The strategy would be effective as long as government bond yields remained below pre-agreed limits set for the derivatives.

“LDI had been thought of (among clients) as a fire-and-forget strategy,” said Nigel Sillis, a portfolio manager at Cardano, which offers LDI strategies.

The industry had been “a little complacent” about the know-how among pension trustees, he added.

The risk escalated over time. A senior executive at an asset manager which sells LDI products said leverage increased, with some managers offering tailored products of five times leverage, compared to a maximum of two or three times ten years ago.

Pension schemes had rarely been requested to offer additional collateral before this year, and a risk-averse industry had become less cautious, the executive said, speaking on the condition of remaining unnamed.

TPR says no scheme has been at risk of collapsing — growing yields actually enhance the funding position of funds — but schemes did not have access to liquidity. In that context, the regulator this week agreed that some funds would have been affected.

When yields rose in an unprecedented move between Sept. 23 and Sept. 28, pension schemes were left racing to obtain cash for collateral. If they did not obtain it in time, the LDI providers close down their hedges, leaving schemes exposed when yields fell following the BoE intervention.

A small minority of schemes would have experienced a 10-20% worsening in their funding position, according to Nikesh Patel, head of client solutions at asset manager Kempen Capital Management.

Simon Daniel, partner at law firm Eversheds Sutherland, said pension schemes were now organizing standby facilities with their financing employers to raise cash for collateral.

Warnings

Risks in LDI had declined for years.

The Bank of England’s Financial Policy Committee underscored the need to regulate risks around LDI funds’ use of leverage in 2018, BoE deputy governor Jon Cunliffe said in October. There were more warnings this year, particularly as rates started to rise.

Pensions consultants Mercer cautioned clients in June to “act quickly” to make sure they obtained cash. Aon said in July that pension funds should get ready for “urgent intervention” to shield their hedges. TPR had “consistently alerted trustees to liquidity risk”, CEO Charles Counsell said this week.

Yet in the slow-moving world of pension funds, where consultants and trustees tend to formulate investment strategy shifts over years, not weeks, few funds were shrinking leverage or increasing collateral, according to trustees and consultants.

Some of the most advanced pension schemes were even loading up on LDI this year, after rates began to soar.

The Universities Superannuation Scheme, Britain’s largest pension fund, earlier this year partly tied a decision to increase exposure to LDI to the “distinct possibility of further falls in UK real interest rates”, against which it required to shield its 90-billion-pound portfolio. Britain’s three-decade inflation-linked bond yield has grown threefold since late June.

In a statement this week USS upheld its approach, noting it had enough cash to satisfy margin calls and that it was not a forced seller of assets. It said it was comfortable if rates were hiked and hedging became more expensive.

That discussion had barely begun elsewhere.

“When people talked about interest rates, all they obsessed about was interest rates falling,” said David Fogarty, an independent trustee at professional pension scheme trustee provider Dalriada Trustees.

“There were not many discussions about leverage either.”