State of the nation – Capital market conditions and LDI
15 November 2022
In one of the most popular webinars we’ve ever run, First Actuarial partner Richard Lunt revisited recent market turmoil – the gilt market crisis and its impact on LDI and scheme funding – and asked, is the situation really as bad as some commentators have suggested? In this article, we provide the full recording along with a summary.
Rather than plunging straight into the run on gilts and its impact on Liability-Driven Investment (LDI) and scheme funding, Richard started by building a broad picture of global and UK markets. He went on to explain what happened during the crisis and then considered key questions, such as what individual schemes should be doing and whether LDI remains appropriate.
Starting with global equities, Richard showed that values in this market have fallen – usually a sign of underlying economic trouble. What has caused this? Apart from lingering Covid effects, the invasion of Ukraine has undermined confidence in the global economy, and rises in gas and oil commodity prices have had an inflationary effect.
But this is a UK-specific shock. Homing in on UK equities, we see a market that is less diversified than its global counterpart and is mirroring its problems. The relatively strong recently performance of the FTSE 100 index is misleading as it’s due to significant distorting factors.
Inflation is high – 10.1% at time of writing. This has led to significant increases in gilt yield, with everyone anticipating rises in base rates. Although that is the case in many developed countries due to Covid spending, the UK has a debt to GDP ratio of over 100% and is also running a budgetary deficit.
Finally, market discomfort with political uncertainty spilled over with the mini-Budget and the Chancellor’s announcement of cutting taxes funded by borrowing – an inflationary move. The Bank of England had been trying to control inflation by raising interest rates. The run on gilts at the end of September was a consequence of markets’ loss of confidence faced with these conflicting approaches.
This is where LDI comes in. First Actuarial has produced an explainer video about LDI, which Richard summarised. In economic terms, LDI is similar to holding a portfolio of gilts which is partly funded by borrowing.
LDI does not behave like other asset classes. With LDI, schemes need to manage the leverage. In the gilt crash, schemes borrowed to purchase assets which then fell in value. The effect was akin to a highly mortgaged household in a housing market crash.
In the ordinary course of business, schemes periodically add or remove cash to manage the leverage. But with a sudden, sharp drop in gilt values, it may not be possible to inject the cash quickly enough to satisfy the requirements of the LDI manager. In that situation, the LDI managers are within their rights to reduce leverage by selling some of the scheme’s gilts. This put some schemes in the unenviable position of having to repurchase gilts at a higher price to regain lost protection.
Some LDI providers had to scale down the protection they offered schemes, disposing of gilts at fire sale prices. Only when the Bank of England stepped in with its asset purchase programme, buying gilts back so schemes could reduce their leverage, did the gilt yield come back down and more normal market operation return. The market became more orderly, although the value of gilts remained volatile.
Bank of England intervention came to an end on the day of this webinar.
What position are schemes in?
Richard was unable to address individual arrangements in the webinar, and instead outlined a range of positions in which schemes might find themselves.
The position of many schemes is likely to have improved materially. Positive scenarios include an under-hedged scheme with some LDI and a provider that has withstood the market shock.
Schemes in an improved position may want to take pragmatic steps to hold on to their gains. Some schemes are seriously looking at insurance buy-out and want to protect their position.
A limited number of schemes find themselves financially worse off. In First Actuarial’s experience, however, the damage incurred is tolerable for most schemes adversely affected.
Is LDI still appropriate for schemes?
In recent weeks, some well funded schemes – now wary of the risks associated with managing leverage – have started to consider protecting their position with conventional gilts instead.
However, Richard believes strongly that LDI will continue to have a place in the pension scheme world. LDI may prove useful if interest rates fall again, and it can also help schemes improve their position using growth assets rather than cash contributions from the sponsor.
That said, the risks associated with LDI need to be considered. Advisers are talking about a new world of LDI, with funds operating at lower levels of leverage than before. This may make investment strategies less capital-efficient. And although capitalisation calls are less likely to happen in future, because of the de-leverage, where will that capital come from when LDI funds absorb so much cash?
The bottom line, however, is that LDI funds can withstand more market shock than was the case a few weeks ago. Many trustees are likely to conclude that the benefits of LDI outweigh its now moderated risks.
The Pensions Regulator (TPR) is encouraging trustees and their advisers to obtain an accurate position in order to make an informed decision. Richard reiterated this. However, he emphasised that in seeking a sound estimate of their financial position, trustees should be aware of two challenges in the current conditions.
Firstly, it may not be easy getting accurate asset values from LDI providers at this point, for example due to recapitalisation payments in transit. Secondly, in volatile conditions, the day you choose for your funding update can have a material impact on the results. It’s important to take a rounded view rather than trying to take a snapshot and acting solely on that position.
Many schemes will need to review their investment strategy, even if their position has improved. Recent events have altered the asset mix. Liabilities and matching assets will have shrunk relative to growth assets. Portfolios will contain a higher proportion of illiquid investments. Also, the capital calls will have altered the balance between bonds and non-bonds.
Another point of agreement between First Actuarial and TPR is that this is not all bad news. That is not to detract from the limited number of schemes that have lost their hedging and must now replace it at greater cost. But whether yours is one of those schemes or not, it’s important to take a broad look at conditions and how they affect your particular arrangement.