A Review of Institutional LDI Strategies - H1 2022

As we end the first half of 2022, it’s worth reflecting on the impact of investment market performance on pension schemes, and in particular for Liability-Driven Investment (LDI) portfolios. H1 2022 has been significant in so many ways with equity market, sovereign and corporate bonds all seeing one of their worst six months in history.

Market background and the impact on pension scheme deficits

For a UK DB pension scheme, based on information available from the Pension Protection Fund (PPF), we estimate that this would have resulted in an overall negative return of around 25-40% for many schemes (allowing for the leverage within LDI portfolios). Although this is likely to be one of the worst periods on record for assets, ironically, for some schemes, the funding position has never been better. This is because the value of their liabilities has decreased significantly due to the rise in nominal and real gilt yields, which means that we expect the overall deficit to have reduced for many schemes. On a buyout basis, the position is likely to be even better due to widening of credit spreads playing a part in more attractive buyout pricing (if you can get a quote! – a discussion for another day).

LDI strategies and collateral requirements

Designed over 15 years ago to help address funding volatility, what can we say about LDI strategies after this rocky start to 2022? LDI strategies are predominantly investments in government bonds (nominal and real) that use leverage in order to mimic the return of pension fund liabilities.

LDI strategies have mainly existed during a bull bond market, with interest rates falling over a long period of time, further than many investors anticipated. Many schemes have been rightly prudent when setting up these strategies with other liquid assets assigned as contingent in case of collateral calls. There have been a few periods of panic for interest rates when this collateral has been needed, such as in March 2020 at the outbreak of the pandemic. However, these have typically been short, sharp spikes that reversed quickly with cumulative moves of less than 1%.

So LDI has worked well, limiting funding ratio volatility during the last 15 years, with limited requirement for additional collateral. Importantly, LDI has also been a source of income generation, with the positive return redistributed to schemes as a dividend on a regular basis. But how did it perform this year, when yields sold off for a prolonged period time (a cumulated rise of 2%, nearly tripling long-dated sterling rates over a six-month period)?

Mechanically, these strategies have had a negative return, which resulted in collateral calls to replenish fund values and maintain hedging levels. This process has been tested before and worked well, with clients having successfully ring-fenced their contingent assets.

However as yields keep rising, it’s highly likely that the number of collateral calls is now greater than one, with any contingent assets earmarked at the outset exhausted. Trustees are asking the question: Which investments are we going to redeem next if rates continue to rise? If you look narrowly at each asset class there’s no easy answer.

What about equities? Markets are down significantly and trustees are rightly cautious about selling and missing a rebound.

What about corporate bonds? For the first time in many years, investors are viewing corporate bonds as attractive. Selling now would likely crystallise losses. Additionally, credit likely forms part of the endgame portfolio as it constitutes most insurers’ asset of choice for hedging pension liabilities. Selling now takes the scheme further from this long-term portfolio.

And what about illiquid assets? This original small allocation is now mechanically bigger due to the fall in overall scheme assets. While overweight, by definition it’s difficult / costly to sell such assets and therefore unlikely to be a viable option.

If there is no appetite to sell assets, the scheme runs the risk of being unable to accommodate an increase in liability hedging that its higher funding ratio would imply. An even worse scenario would be the inability to maintain hedging targets if rates continue to rise, which goes against many schemes’ objective of minimising unrewarded interest rate and inflation risk.

“…many schemes’ funding positions have actually improved over the past six months, at least on a buyout basis, which means reducing growth assets may be an option.”

Coming back to the introduction, many schemes’ funding positions have actually improved over the past six months, at least on a buyout basis, which means reducing growth assets may be an option. This is where taking a more holistic view of pension schemes’ position can help the decision-making process compared with narrowly assessing the pros and cons of each fund / strategy within a portfolio

A clear de-risking plan with appropriate delegation

Across our clients we notice that those with an established de-risking journey in place (based on funding levels), together with the relevant transfer of dealing authority, have been through these six months relatively stress-free. Many triggers have been breached, with a smooth transition to a low-risk portfolio freeing up additional cash required to support the LDI portfolio through rising rates.

On the flipside, clients that have decided to keep control of the overall strategy have experienced governance bottleneck issues, which has preventing them from being reactive.

Conclusion

Risk management within LDI is well established and has again proved its worth through the last six months. But what has been lacking in some cases is the holistic view of the overall strategy versus the scheme’s ultimate goals. It’s all connected and you need a strong governance framework to ensure optimal decisions are made across the portfolio, including when it comes to LDI collateral choices.

Enhancing the governance framework through increased delegation, whether via a fiduciary arrangement or enhanced service from the asset manager, together with a clear de-risking framework can help ensure that investment solutions remain aligned with trustees’ overall scheme objectives, even during volatile market conditions.