Britain’s largest pension system was warned about a debt strategy ahead of the crisis

The UK’s largest private pension scheme increased its exposure to debt-driven investment strategies earlier this year, despite warnings that the move would entail “significant risks”.

The £90bn university pension scheme put more of its members’ assets into leveraged hedging, the strategy caught in the crisis last week after a surge in government bond yields prompted emergency intervention by the Bank of England.

The proposal was spearheaded by USS chief Bill Galvin, who was head of the pension regulator before joining the plan.

Several of the scheme’s high-profile employers, including Cambridge and Oxford Universities and Imperial College London, had opposed the move after it was proposed in February over concerns that a greater reliance on leverage would lead to a fire sale of assets in volatile markets could lead .

“We believe that increasing leverage at a time of high market volatility has the potential to introduce significant risks into the program,” Cambridge, Oxford and Imperial College wrote in a February letter to Galvin.

The warnings proved prescient as gilt yields soared last week and many pension schemes using so-called liability-driven investment strategies were forced to sell assets to raise cash to meet demands for collateral.

The USS said it was not “forced” to sell assets by the turmoil in the gilt market triggered by Chancellor Kwasi Kwarteng’s unfunded tax cut announcement on March 23.

“While navigating market conditions was challenging — in terms of the speed of response required — it was manageable,” USS said, adding that it had received broad support for its proposals.

According to a consultation letter sent out in February, the USS proposed increasing its exposure to LDI from 35 percent to 52 percent of its portfolio, with leverage more than doubling from 17 percent to 37 percent of weighted assets.

USS told the Financial Times that it is unable to provide current leverage or LDI values ​​as they change almost daily. However, in a March 2022 implementation update, the leverage was 27 percent of the portfolio weight and the LDI was 34.8 percent.

LDI is a risk management tool used by schemes to protect annuities from adverse interest rate movements and to ensure funding levels do not deteriorate when interest rates fall. Some plans use leveraged LDI, or short-term debt, to fund purchases of additional growth assets.

At the height of the gilt crisis last week, thousands of defined benefit plans with LDI strategies faced a liquidity squeeze as contingency collateral was required for those contracts when government bond yields soared.

USS noted that “from a funding perspective, rate hikes have positive implications.” However, it added that the volatility in the UK market, “clearly driven” by recent government announcements, makes it “very difficult to provide a long-term view”.

A re-examination of USS’s investment strategy, particularly its increased use of leverage, comes as regulators anticipate calls for more rigorous oversight of the use of leverage by pension funds.

The pension regulator does not currently collect detailed data on the level of collateral or leverage contracted by defined benefit schemes, nor does it require each scheme to provide such data.

Bernard Casey, a retired academic and founder of think tank Social Economic Research, said: “Pension funds that use leverage act like shadow banks that are themselves poorly regulated. What we have seen over the last few weeks is the chickens coming home to settle on LDI.” Britain’s largest pension system was warned about a debt strategy ahead of the crisis

Adam Bradshaw

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