The crisis in Britain’s defined benefit pensions market last week was like a replay of the 2008 banking crisis — just with different acronyms. It was caused by a blow-up of LDIs — or liability-driven investment strategies, a vast £1.5tn corner of the financial markets that most people had never even heard of. Half a dozen lessons from 2008 have not been learnt.
1. There’s no such thing as risk-free. Aside from the three-letter shorthand, LDIs have at first glance little in common with the CDOs, or collateralised debt obligations, the financial instruments that spread the contagion of defaulting subprime mortgages a decade and a half ago. Pension funds were at risk, not banks. And the trigger was a price collapse in government bonds, not home loans. Yet there are clear parallels — most obviously, the AA-rated gilts that underpin LDI strategies were treated as risk-free, just like the AAA-rated CDOs that spiralled into near-worthless junk. Even if you accept that the credit risk on gilts is pretty minimal, the market risk in these normally ultra-liquid securities has been routinely underestimated.
2. Ultra-low interest rates have obscure side-effects. Years of low interest rates in the run-up to 2008 had encouraged a debt-fuelled “search for yield” that took investors into high-risk assets. The even lower rates that followed 2008 had a profound effect on DB pension funds. The gilts and bonds of these funds were not returning enough to match the schemes’ liabilities. LDI, based on borrowing (or “repo-ing”) against the collateral of low-yielding gilts, became an increasingly popular way for schemes to offset the shortfall. But what started as a hedge in some cases became a leveraged bet — an irresistible way to “juice” otherwise low returns.
3. Liquidity and capital are intertwined. Back in 2007-8, banks and their regulators initially argued that the system was afflicted by a liquidity crisis driven by a fearful drying-up of funding markets, rather than more profound weaknesses. A similar argument was made about the pension fund tumult last week. Supposedly, the schemes were merely experiencing a temporary shortage of collateral to cover their gilt repo activity, and that caused a panic. The argument was that underlying funding of the pension schemes, thanks to those higher gilt yields, was actually looking healthier from an actuarial point of view. In practice, though, a sharp devaluation of gilts that might not last is a flimsy basis for funding pension payouts. Happily, the Bank of England’s speedy gilt-buying intervention seems to have staunched the problem for now.
4. Amateurish governance is dangerous. One of the lessons of bank failures in 2007-8 was that expertise matters: having a retail boss run a bank (as was the case with the failed HBOS) was probably unwise; many bank boards lacked the skills and knowledge to be effective overseers. Similar criticisms have been made for years about the amateurishness of some pension fund trustees, yet little has been done to professionalise a system that governs the retirement prospects of millions.
5. Regulation is lacking. Whenever a crisis grips part of the financial system, it is tempting to squeal: “Where was the regulator?” In the case of the LDI ructions, the UK’s Pensions Regulator can claim to have been alive to the risks. Only last month, its lead investment consultant wrote that some pension scheme trustees were “underprepared” for the collateral calls that rising interest rates would mean for their LDI portfolios. But the tone, in a blog, was reminiscent of the way the BoE, as the 2007-8 crisis loomed, would point out that it was aware of developments and had warned about the risks in speeches and papers. The BoE did little in practice, partly because it lacked powers. Post-2008, rules were introduced on bank capital and liquidity, and regulators started annual industry stress tests. The Pensions Regulator could do with tougher powers, too.
6. Policymakers could make things even worse. Governments and central banks paved the way for the 2008 crisis, with free money and lax regulation. Yet lawmakers are once again pushing deregulatory agendas. In the US last week, Republican senators introduced a new bill arguing that crypto assets as well as private equity should be allowed in private pension plans. In the UK, the government wants to make it easier for pension funds and life insurers to invest in riskier assets — putting a political imperative ahead of concerns about asset illiquidity and risk. When you espouse such policies, you’re asking for trouble — again.
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