End of Bank of England intervention – next steps | 10 October

Last week saw significant activity for all DB pension schemes, in response to the changes being made by LDI managers to reduce leverage levels in their LDI pooled funds and segregated portfolios. It was a busy week, and in most cases, this involved arranging the sale of assets to fund the collateral calls being made. 

This week looks set to involve similar challenges, as LDI managers continue to announce changes to the operational levels of collateral in their funds. This follows a gradual rise in yields after the Bank of England’s (BoE) “temporary and targeted” intervention was announced on 28 September, making managers nervous about the outcome of the intervention ending on 14 October. Could we see yet further yield volatility? 

The BoE published this letter, explaining the temporary intervention, and further announcements were made today about additional support mechanisms now being put in place. However, the 14 October date remains a key point when the long-dated gilt purchase scheme is due to end. So, how does the situation look for pension schemes going forwards?

Considerations

Despite the urgency of the situation to meet the collateral calls last week (and possibly this week), for most schemes that are not fully hedged on their buy-out liabilities, the recent rise in yields will have seen funding levels improve, potentially significantly. 

Liabilities will have fallen by more than the scheme assets, because while growth assets, like equities, have also seen recent volatility, they haven’t fallen in value by as much as the liabilities. For most schemes, last week’s events were more about managing liquidity than affordability – selling down growth assets will have been a strategically sound decision for most, as well as a necessity in order to maintain hedging levels. This is because: 

• with many funding levels improving, schemes won’t need to hold such a high proportion of assets in growth assets;
• many schemes were overweight in growth assets and required rebalancing due to the better performance of equities, say, relative to other assets; and 
• with the absolute size of many schemes falling, the amount of growth assets needed has been scaled back (i.e. a 20% allocation to equities in a £100m scheme is £20m, but only £16m if the scheme is only £80m in size now). 

A consequence of the speed of action needed is that many schemes will have made decisions which prioritised de-leveraging and maintaining hedges, and often based on incomplete information. All impacted schemes will now need to take decisions about their investment strategies more widely. Some of the key issues to focus on, in our view, are:

• the “new normal” for leveraged LDI funds, and the impact on hedging strategies;
• collateral levels and waterfalls; and
• where to top up collateral from.

Taking each of these in turn:

The “new normal” for leveraged LDI funds, and the impact on hedging strategies

A key next step will be to assess the funding level of your scheme, the impact this has on the required level of investment returns needed, and the appropriate level of hedging. 

All circumstances will be different, but where funding levels have improved, the required allocation to return-seeking assets may have fallen sufficiently to maintain, or even increase, interest rate hedging longer-term, while also holding sufficient collateral (see next section). For others, hedging may need to be reduced, but we think this should be done in a controlled way, rather than defaulting to a lower and uncertain hedge level because of being unable to meet a manager’s particular collateral call. 

Collateral levels and collateral waterfalls

The “whipsaw” risk of yields rising, collateral calls not being met, hedging being cut, and a subsequent fall in yields remains heightened. In this scenario, schemes could suffer a funding level deterioration. This risk could be removed going forwards by transferring away from LDI funds, but for most schemes, replicating the existing hedging strategy won’t be possible without using leverage or suffering a significant deterioration in future return potential – unhedged interest rate risk is still the most significant risk for most schemes, so materially reducing hedging is unlikely to be a palatable route.

Instead, we expect most schemes will need to give more detailed thought on their approach to collateral levels, particularly after a week when collateral has been diminished for many schemes. The solution to mitigating the whipsaw risk is to ensure there is more than adequate access to liquid collateral assets, combined with lower leverage in the LDI strategies themselves. This is not just about the leverage of the LDI Funds themselves (i.e. the main issue last week) – it’s about mitigating the risk that the scheme is unable to meet calls for cash for “normal” de-leveraging events going forwards. 

We are still working with the LDI managers to understand how their LDI Funds will operate under the lower leverage levels that they have now introduced (and are continuing to refine). We might even expect  a starting point for discussions, however, to be to hold 50% of a scheme’s LDI Fund values in highly-liquid stable-value assets – cash funds, money market funds etc.. Holding these assets directly with the LDI manager, as part of a pre-defined waterfall structure, is likely to be the preferable approach going forwards too, so that no trustee action is needed to access them.

Where to top up collateral from

The need to review collateral raises questions about the overall liquidity of assets. Last week generally saw sales of liquid assets – many less-liquid funds, such as property managers, have started to put restrictions on some of their dealings, such that the time taken to receive proceeds from sales is many months. And, if protection assets and liquid growth assets have all fallen in value, the proportion of a scheme’s illiquid assets will likely now have increased. 

Remembering that a scheme’s primary role is to pay benefits, any LDI-related decisions need to be made cognisant of maintaining sufficient liquidity across the scheme’s assets as a whole to achieve this. Previous allocations to illiquids may now represent a greater proportion of total assets, taking into account market moves, so thinking about this now is crucial. Further yield movements could quickly mean this becomes more and more significant. This requires consideration of whether the strategy has sufficient liquidity overall, especially if yields rise much further, and whether the illiquid asset allocation pose a risk to overall portfolio diversification.

Summary

We’re already working to think about these issues in detail, but the specifics will vary from client-to-client, and we’ll be in touch with all of our clients to discuss next steps. In the meantime, feel free to get in touch at any time.

For professional use only. The above is for information purposes only and should not be construed as investment/regulated advice. Please contact your Barnett Waddingham consultant if you would like to discuss any of the above topics in more detail.