The next crisis that could hit the pensions industry
Recent demonisation of liability-driven investments could do disastrous damage, finds Oliver Gill
‘We had more major moves in those last three weeks than we have had in the history of the gilt market’
As the dust settles on one crisis, fears are growing that the pensions industry is in danger of unwittingly lurching into another. Economic Armageddon was on the horizon just weeks ago. The Bank of England was forced to step in amid warnings of a “material risk to UK financial stability” in the wake of a run on pension schemes likened to that of the crisis facing Northern Rock before its collapse in 2008.
Liability-driven investments (LDIs), a central pillar of pension investment strategy over the past two decades, have been widely blamed for the crisis.
Experts now fear that their “demonisation” could have disastrous consequences for pension trustees and company boards alike. Trading out of LDIs risks stranding hundreds of UK final salary pension schemes that are in deficit, they say.
Meanwhile, the fallout could act as a squeeze on corporate growth – just as Britain heads towards a recession.
“If companies and their pension schemes back away from using LDI to control and fix their deficits there is a real risk that, depending on market movements, they may be forced to divert cash away from the business and into their pension schemes,” says Dawid Konotey-Ahulu, who lays claim to having put together the first LDI when working as an investment banker at Merrill Lynch two decades ago.
LDIs are fiendishly complicated. But at their heart is a comparatively simple tenet: by taking out loans against investments they already own, fund managers can supercharge their returns and close funding holes that had opened up by the turn of the millennium.
Critics claim this created a “time bomb” in Britain’s financial system. But supporters argue that this was a bona fide risk management tool. LDIs allow pension funds to swap riskier equity investments for bonds so that assets could be better matched to retirement obligations. Lower interest rates meant higher liabilities but increased the value of assets, and vice versa.
The Pension Protection Fund (PPF), which monitors the roughly 5,000 schemes in the UK, estimates 750 of them are in deficit.
Fears of a repeat of the recent run on LDI strategies has put pressure on pension fund managers and trustees. Many have been left with a difficult decision: either trade out of LDIs entirely; or stick by them but opt for less aggressive investment strategies that require significantly more capital to be injected.
Trading out of LDIs completely does not seem to be an option, according to Lane, Clark and Peacock (LCP). It surveyed 400 trustee and company representatives earlier this month, 90pc of whom said LDI strategies will continue to have a role.
However, Steve Hodder, a partner at the consultancy, says there is “clear acknowledgment that LDI strategies will need to be evolved for the environment we now find ourselves in”.
Toning down LDI investments, which will likely require companies to inject more capital into their retirement funds, will have serious implications, Konotey-Ahulu says. “LDI is a highly effective way of stabilising and repairing a pension scheme’s deficit so that the company does not have to worry about whether it will have to make additional contributions into the pension scheme instead of paying dividends or investing in growth and innovation,” he says.
The 750 or so pension schemes that are underwater may now feel they have missed their chance to turn a deficit into a surplus.
In the early 2000s, Britain’s pensions were in a mess. Under Tony Blair and Gordon Brown, Labour had brought in new laws forcing company boards to look at their retirement obligations more carefully.
Pension deficits were “brought onto the balance sheet” for the first time.
By 2003, the combined deficit of the FTSE 100 was £55bn, LCP said at the time. Even Watson Wyatt, a pension adviser to most of the UK’s big companies, had a large hole its own retirement fund.
The consultancy’s latest analysis of the FTSE 100 found that companies on the blue-chip index now boast a combined surplus of £160bn.
The chief executive of one of the City’s biggest institutional money managers says: “You have to remember, LDIs have done a huge amount of good, as witnessed by the current healthy state of UK pension funds.
“If you look at how pension funds have fared versus other countries like the US, the UK is in much better shape because it was an early adopter.”
But what most proponents of LDIs had not envisaged was a blowout of the bond market in the wake of Kwasi Kwarteng’s now hastily reversed mini-Budget.
“The reality is that we had more major moves in those last three weeks than we have had in the history of the gilt market,” says one senior City source.
Konotey-Ahulu says: “LDI is, ironically, about driving UK growth by allowing companies to focus on their core business, leaving pension schemes to stabilise their deficits and reach full funding over the next few years.
“There are lessons to learn and areas for improvement but the demonisation of LDI in the last few weeks has been deeply unfortunate. There is a risk it causes pension schemes to move away from the very protection they need.”