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UK pension schemes confronted by growing liquidity strains

Soaring inflation and rising interest rates are placing unprecedented liquidity strains on some of the UK biggest pension schemes, according to industry experts.

A growing number of schemes have found themselves forced to sell liquid assets, such as equities and investment grade corporate bonds, to raise cash to replenish collateral — money offered as security — needed to ensure their long-term plans remain on track.

Final salary pension schemes over the past 20 years have increasingly turned to leveraged gilt investments and derivatives contracts linked to long-term interest rates and inflation to reduce the risk they might be unable to pay the retirement incomes promised to members.

This approach, known as liability driven investment (LDI), has become a core investment strategy for many final salary or defined benefit (DB) pension schemes.

Liabilities held by DB schemes — the estimated value of future retirement benefit promises — stood at just under £1.7tn at the end of March 2021, according to the Pension Protection Fund.

Between £1tn and £1.5tn of the liabilities held by DB pension funds are covered by LDI strategies. These now face their biggest test since the market was created in 2001 in a deal between Boots, the high street chemist, and Legal & General Investment Management (LGIM).

Akin to remortgaging a house to buy a second property, many pension schemes enter repurchase agreements on their existing gilt holdings in exchange for cash to buy more gilts to cover future liabilities.

But sharp declines this year in bond prices have resulted in more schemes being pushed into selling liquid growth assets to satisfy demands for additional cash as collateral for LDI strategies, which are run by third party managers. These growth assets, such as equities and credit, have themselves also fallen in value, exacerbating the problem.

The three largest players in the LDI market — BlackRock, LGIM and Insight Investment — have all issued collateral calls to UK pension clients so far this year.

Mercer, an investment consultant, has sent out a “call to action” to its UK pension scheme clients, urging them to prepare for additional collateral calls to safeguard their LDI strategies.

Daniel Melley, head of UK investments at Mercer, said LDI portfolios were being subjected to “unprecedented liquidity strains” due to sharp increases in interest rates.

Yields on 20-year gilts — the key long-term interest rate that pension schemes use to measure their liabilities — have risen by more than 1.5 percentage points so far this year, the sharpest increase since the early 1990s.

Line chart of UK 20-year gilt yield (%) showing Long-term interest rates have surged higher

“A significant proportion [of DB pension schemes] will need to act quickly to ensure they have the ‘dry powder’ available to meet further collateral calls if interest rates rise further. Eligible assets — typically cash and gilts — will have to be made available in a matter of days. This could be challenging, particularly where there are currency implications from selling [other liquid] assets,” said Melley.

BlackRock, LGIM and Insight all insist that the existing arrangements within LDI strategies to sell assets are robust enough to cope with further increases in interest rates.

However, Simeon Willis, chief investment officer at the consultancy XPS, says the “staggering increase” in interest rates this year has now surpassed the typical stress test — a 1.5 percentage point rise in long-term gilt yields — commonly employed by LDI strategies.

As a result, some pension funds could be forced to sell growth assets that they would prefer to retain, he said.

“The increase in long-term interest rates is dramatic and has not been before witnessed by the LDI industry. Some pension schemes that have not planned their liquidity requirements appropriately could very well find themselves compromised,” Willis said.

Mercer has also warned that some pension schemes might need to accept lower levels of hedging — protection against possible declines in interest rates — if they were to run out of liquid assets that could be used to top up collateral in their LDI strategies.

“The possibility of this scenario should be assessed and discussed with sponsors [employers that make financial contributions to DB pension schemes], said Mercer.

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Guy Whitby-Smith, head of solutions portfolio management at LGIM, said the increase in long-term yields had created a more attractive pricing point for any schemes that wanted additional hedges against liabilities.

“DB pension schemes are 80 per cent hedged on rates and there is now an opportunity for schemes to hedge the remaining 20 per cent of their liabilities,” said Whitby-Smith.

Jos Vermeulen, head of solution design at Insight Investment, said that most DB pensions schemes saw an improvement to their funding position last year and could afford to make the adjustments needed to maintain hedging ratios for their liabilities.

“Pension schemes can use derivatives to replicate some of their existing equity or credit holdings if they want to raise cash by selling assets. Some schemes will also have cash flows from maturing mandates or from contributions which can also be used to top up collateral within their LDI strategies,” he said.

Around two-thirds of DB pension schemes introduced arrangements in 1997 that limited future increases in retirement payouts due to inflation to 5 per cent. However, no such cap is built into the hedges in LDI strategies against UK inflation, which was running at an annual rate of 9.1 per cent in May.

“This is a mitigating factor which should provide a boost to the funding position of DB schemes,” said Vermeulen.

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