Pension funds should be as solid as the Rock of Gibraltar. The fact that many of them were found to be behaving more like hedge funds is deeply troubling. It demands another deep dive into the UK’s regulatory system. By Justin Pugsley.
What is happening?
The blow-up of many leveraged pension fund liability-driven investment (LDI) policies has raised many questions, some which should have been definitively answered. It will surely result in calls for tighter regulation and better governance of pension funds, but possibly also on the banks and investment advisers who sell LDI products.
LDI is a strategy designed to match pension fund assets with their liability profile.
On September 22, UK government bonds or gilts plunged by the largest amount since the Covid-19-related ructions in March 2020. This move was triggered by unfunded tax cuts by the government of new UK prime minister Liz Truss. Her policies imply more gilts and wider government deficits.
The situation was made worse by the Bank of England announcing beforehand that it was going to conduct quantitative tightening — i.e. selling gilts. Another factor was that it ‘only’ raised the UK base rate by 50 basis points, compared to the earlier 75 basis point hike by the US Federal Reserve, making the former look softer on inflation. Throw in that the UK is mired in stagflation and sports a staggering 8.3% current account deficit, and all the ingredients were neatly lined up for a rout in gilts and the pound.
Why is it happening?
Pension funds are supposed to be very safe. A plunge in gilt values should not be an issue — if anything, correspondingly higher yields should make it easier to support future pension liabilities.
For years, ultra-low interest rates have left pension funds struggling to meet those liabilities. So, to address their deficits, they turned to a familiar tool common to most financial crises: leverage.
In essence, they took their gilt holdings and used them as collateral to buy more of them through various derivatives contracts. This was designed to boost yields.
The problem is their narrow focus on credit quality while overlooking market risk, which becomes an issue when using leverage.
As gilt prices plunged, pension funds were faced with an avalanche of margin calls, necessitating selling gilts — the most liquid instruments — to meet them. This threatened to degenerate into a self-reinforcing downward spiral potentially triggering a systemic crisis.
The vicious cycle was only broken by an emergency Bank of England intervention. It switched from a quantitative tightening stance back to one of easing, i.e. by promising to temporarily buy unlimited gilts to stabilise the market.
What do the bankers say?
A more conservative approach to investing by pension funds means they will be using more vanilla services — i.e. buying less of the more profitable derivative structures.
Banks might be asked to treat pension funds, particularly smaller ones, more like retail clients — i.e. people of relatively low sophistication. Indeed, many pension fund trustees have a more limited knowledge of risk and financial markets than bank professionals.
But some are reaping big rewards from the storm. Several asset managers, some owned by banks, are gleefully snapping up less liquid assets from pension funds, such as private equity stakes, at big discounts. Many of these deals will be brokered by banks, and all of this will no doubt rile policy-makers anticipating a public backlash.
Will it provide the incentives?
There are two very troubling implications from this debacle. UK regulators once again need to do some deep soul searching as the country was nearly the epicentre of a global financial crisis at a terrible time for the global economy. Also, UK regulators were repeatedly warned about the dangers of leveraged LDI schemes and chose to do nothing — an unfortunately familiar tale.
One plus is that soaring interest rates should make pension funds feel less inclined to lean on leverage to pump up yields.
Secondly, there is a growing fear that the LDI mess might only be the tip of a very large iceberg. Bank credit default swaps have been ballooning, as have spreads of lower credit bonds. Also, more warnings have been sounded over forced selling by open-ended funds amplifying falling markets. Unfortunately, the LDI wreck may only be a prelude to a torrid 2023 as the ‘everything going up’ rally turns into a prolonged bear market. Systemic considerations may end up forcing central banks to moderate tightening monetary policy.
