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The pension investment strategy that fuelled last week’s crisis in the UK financial markets was not designed to withstand such volatile moves, according to a leading City figure who helped introduce it.
The strategy, known as liability-driven investing (LDI), is at the centre of the pensions industry turmoil that last week prompted a £65bn Bank of England intervention as thousands of schemes teetered on the edge of default.
Dawid Konotey-Ahulu was part of a team at US bank Merrill Lynch that in 2003 developed LDI in a bid to “immunise” defined-benefit pension schemes against large movements in interest rates and inflation, he said.
It “has helped stabilise pension funding over the past two decades”, Konotey-Ahulu told the Financial Times in an interview.
“What happened this week was the gilt market got hit by the equivalent of a category-four hurricane and the LDI system wasn’t built to withstand a weather system of that ferocity.”
Konotey-Ahulu went on to co-found Redington, a City firm advising large institutional pension funds and insurance companies.
He said that at the time the investing strategy was developed two decades ago, “UK defined-benefit plans existed in a state of uncertainty . . . [they] simply didn’t know whether they had sufficient assets to pay the pensions of all their members as they fell due”.
The LDI contracts that Merrill Lynch used allowed pension funds to mirror movements in their liabilities, with the aim of minimising the risks for the scheme and the beneficiary of the pension.
Since 2003, LDI has become widely used by the UK’s 5,200 defined-benefit plans, which have more than 10mn members and £1.5tn under management. LDI strategies are run by asset managers including BlackRock, LGIM and Insight Investment.
But their vulnerabilities were exposed last week as gilt yields rose at an unprecedented pace following the chancellor’s “mini” Budget and thousands of pension plans struggled to meet emergency cash calls on their LDI contracts.
The prospect of a widespread liquidity crisis prompted the BoE to step in and stabilise the market with an emergency bond-buying programme.
Konotey-Ahulu said the crisis was not because of the fundamental concept of LDI being faulty. Up until last week, LDI had “worked like a charm” for pension plans and helped “provide a future for millions of members of defined-benefit funds”.
“It simply wasn’t possible for the entire pensions industry to sell assets fast enough to make its collateral payments,” Konotey-Ahulu said.
However, criticism of LDI has mounted since the market rout. Lord Wolfson, the chief executive of Next, the retail group, said he had warned the Bank of England about LDI, describing the strategy as “a time-bomb waiting to go off”.
Konotey-Ahulu said there was “no doubt” schemes that had employed heavily leveraged LDI strategies “would have experienced more pain” in the past week. But he said the fundamental concept of LDI was still sound but schemes would need bigger collateral buffers to protect them against sharp price swings.
“There can be no doubt that every pension fund will have to take stock of their collateral buffers [following the crisis],” he said.
“But the LDI mechanism has worked up until now. When systems are rocked by unparalleled events, the answer is not to dispense with the mechanism.”
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