Current market volatility and DB schemes solvency | 29 September

What happened?

As you will know, there was a mini-budget on Friday 23 September, when the Government announced substantial tax cuts, which it appears are to be funded primarily through borrowing in the gilt market.  This came after the Bank of England announced the previous day that it would begin a Quantitative Tightening programme (i.e. selling back gilts it had purchased over recent years as part of its Quantitative Easing programme).  In short, there were two events in quick succession which suggested a glut of supply in gilts.  Gilt prices fell very sharply (and gilt yields rose sharply) for several consecutive days as a result. Note that gilt prices and gilt yields are inversely related.

Many DB pension schemes hold a lot of gilts. They do this because their liabilities are valued by reference to the yield on gilts. Most DB pension schemes therefore saw sharp falls in the value of both their assets and liabilities.

However, many DB schemes use leverage within their gilt portfolios – these are usually called Liability Driven Investment (“LDI”) portfolios or funds.  Because these portfolios are leveraged, falling gilt prices caused the value of these holdings to fall very quickly and they become more and more leveraged. The protocol for such situations is that when this happens the fund managers make a collateral call for additional cash – in order to top-up the portfolio and prevent the need to sell gilts.  This brings the leverage back down.  If investors don’t provide the cash in time then the protocol is that the fund manager will sell gilts in the market, again in order to bring the leverage back down to normal levels.

Most pension schemes were able to make collateral payments in time, but some schemes were not. This meant that the LDI managers had to sell gilts in order to bring the leverage back down in their funds. However, they were selling into a market with very little demand, and so the effect of this selling reinforced the falls in gilt prices. This triggered further collateral calls, which again most schemes were able to meet. However, again some schemes were not able to meet the calls, and so this reinforced further the falling gilt prices and rising gilt yields. In addition, some LDI managers took decisions to urgently scale back hedges, again exacerbating the situation.

The Bank of England was worried about this becoming a vicious circle and so intervened in the market, promising to be a buyer of last resort. The effect of the intervention has been to stabilise the gilt market – for now at least. The intervention has been described by the bank as limited – they are not writing a blank cheque and they are not promising to be the buyer of last resort for ever. The intervention is scheduled to end on 14 October. The Bank of England then plans to start Quantitative Tightening (i.e. selling back gilts) from 31 October.

Were DB pension schemes hours from insolvency?

In short, no.  As noted above, most DB pension schemes will have seen improving solvency positions as a result of the rise in gilt yields. Trustees, sponsors and members should be reassured that there is no immediate risk to the ongoing viability of their schemes. Members’ pensions are not at immediate risk.

You say most DB schemes, what about other DB schemes?

Some schemes were unable to move quickly enough to top-up their collateral buffers and some LDI managers and fiduciary managers scaled back hedges pre-emptively. Schemes in these situations will have had their hedging levels cut back, in most cases before the Bank of England intervened.

The Bank of England announcement caused gilt prices to rise back sharply (and gilt yields to fall back). For schemes whose hedges were not scaled back this would simply put them back in a similar position to where they were late last week from a hedging perspective. However, for schemes that had hedges cut back they will be in a worse position now, potentially significantly so, than if their hedges had not been scaled back. This could cause a deterioration in their funding positions, especially for schemes with high hedge ratios.

So why do the media talk about insolvency?

It is true to say, however, that some pension schemes (some of those that implement LDI on a segregated basis), and some pooled LDI funds), were within hours of a technical default on their hedges (i.e. they would have had insufficient cash available to collateralise hedges if yields rose further). Such a default would have been a technical issue for pension schemes themselves though. It would, however, likely have created a substantial ripple effect throughout the wider financial markets, with contagion potentially spreading into the banking sector. The Bank of England therefore stepped in to support gilt prices.

Whilst a technical default would not have been a good outcome, it would not mean that pension schemes would be insolvent or forced into wind-up. It’s not the same thing. It would, however, have led to some legal intervention being required

What are LDI managers doing now?

Initial indications are that some managers are reviewing the ongoing viability of their fund range in light of current market volatility. It may be the case that managers close funds or amend the level of leverage they are willing to offer. At least one manager has already indicated an intention to reduce leverage.

What immediate actions have our clients been taking?

Trustees should continuously review their collateral buffers and collateral waterfalls in current market conditions. This will help avoid potential deteriorations in funding positions if the gilt market continues to experience extreme volatility.

Growth assets are likely to be substantially overweight, despite concurrent falls in equity markets. Schemes can consider rebalancing in order to top-up collateral pools.

Our clients actively engaged with the buy-out market have been discussing with providers whether their transaction remains viable. Many schemes have also been considering an immediate need to revise member option terms in light of the market movements.

Many clients’ funding positions are likely to have changed significantly and therefore reviewing investment strategies, funding plans and journey plans will be very sensible. Many schemes will find that their positions have improved in recent days and they are able to de-risk further. For most schemes, the immediate priority has been replenishing collateral pools and reviewing liability hedging arrangements. Once this is complete then we expect schemes to reappraise the impact on the wider strategy.

What might happen when the Bank of England support ends?

This is very unclear. There remains a risk of continued market volatility once the Bank of England support ends. This makes it even more important to review the resilience of collateral management plans as soon as possible.

This is all about DB schemes – what about DC schemes?

Whilst the fall in gilt values will have affected some individual DC members pots (where they hold gilts) it should not have affected the solvency of the scheme in any way. DC schemes may, however, wish to review whether their investment strategies remain appropriate.

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.