Wealth managers have slashed the level of debt to support pension plan investment strategies following market turmoil triggered by the UK government’s ‘mini’ budget.
Pension fund advisors say leverage for some of the largest so-called liability-driven investing (LDI) managers has almost halved in a week.
The moves increase pressure on pension systems to raise additional money by selling assets or recruiting corporate sponsors for a bailout.
“We’re certainly seeing an immediate reaction as managers across the board deleverage,” said Simeon Willis, chief investment officer at XPS Pensions. “I think it’s pretty inevitable that we’re going to see a more cautious approach to debt after last week’s liquidity crisis.”
Rising UK government bond yields this year have forced pension schemes to add collateral to support LDI strategies that involve derivatives. Last week’s sharp moves in gilt yields, following Chancellor Kwasi Kwarteng’s tax cut announcements, caused a crisis as pension schemes scramble to raise money.
Although intervention by the Bank of England has since stabilized the gilt market, pension schemes continue to face calls for collateral, compounded by new, more conservative stances from banks and wealth managers.
Calum Mackenzie of Aon, the pensions advisors, said: “This is dramatic for the pension funds that have used leverage. The amount of leverage a system needs depends on how much collateral they have. If you have more collateral, don’t use the same leverage. Pension funds with higher return targets would typically have leveraged more.”
LDI contracts are designed to protect around £1.5 trillion of future defined benefit pension plan obligations against adverse interest rate movements and inflation.
The use of derivatives meant pension funds could buy up to £7 exposure to gilts for every £1 invested in the most leveraged LDI strategies, although most used less debt.
“The average leverage ratio before the gilt market crisis was around 2x to 4x for pooled LDI funds and segregated accounts. This is moving towards 1.5 to 3 times multiples in the new world,” said a pensions adviser, who asked not to be named.
BlackRock has made 70 requests for more cash to clients under its £10bn LDI scheme this year. Legal & General Investment Management (LGIM), Insight Investment, Schroders and Columbia Threadneedle have also made similar requests.
“We have reduced leverage in a small number of pooled LDI funds and acted prudently to preserve our clients’ capital in exceptional market conditions,” said BlackRock.
All wealth managers who manage pooled LDI funds for multiple clients now want to build stronger safety buffers into these strategies. As a result, even more cash as collateral is now needed if pension systems are to ensure that protection rates – the amount of their protected assets – are brought back to their target levels.
Dan Mikulskis, partner at pensions advisory firm LCP, said: “The key question now is what is the ‘right’ leverage for LDI funds. The managers decide and communicate that at the moment.”
Managers can reduce the amount of hedging risk offered by each unit of an LDI fund.
“But pension schemes will be able to buy more units with additional assets to ensure their coverage rates can be restored,” Mikulskis said.
A key metric to measure the margin of safety in an LDI strategy is “basis points to exhaustion”, which describes the expected rise in long-term interest rates before more collateral is required.
“LDI managers who liked having a margin of safety of say 150bps or 200bps have decided to increase those margins of safety and require their clients to hold a higher proportion of assets as eligible collateral. This will allow the LDI manager to weather a larger interest rate shock,” said Cardano, a pension investment advisor.
BlackRock has urged its pension fund clients to review their LDI strategies before the BoE’s emergency purchase facility closes on October 14.
https://www.ft.com/content/0ca94705-93d1-41a6-a07f-f63d1a3c4852 Wealth managers reduce debt in retirement plan investment strategies