UK pensions/LDI: crisis fallout has implications for scheme deficits

Hedges are designed to reduce risk. For some UK pension schemes, however, such efforts have had the opposite effect. Unwinding those strategies is a process that could cost shareholders.

This week, BT Group’s pension scheme provided written testimony to MPs explaining that it would take a more cautious view on using now unpopular liability driven investments for hedging. That could mean more cash contributions are needed. Other defined benefit (DB) pension schemes are likely to be discussing similar moves.

For years, DB schemes like the BT Pension Scheme have attempted to hedge against low interest rates. Low rates reduce the discount rates used to determine the present worth of future payouts to beneficiaries. They also lift the present value of assets required to match these liabilities. That is bad news for schemes in deficit. LDI strategies provided a means of hedging the risk of rising deficits.

Now, however, they are being blamed as a source of hidden leverage. Rocketing gilt yield volatility following the proposal of unfunded tax cuts from former prime minister Liz Truss’s government left some schemes in need of more liquidity. Packaging specialist DS Smith admitted on Thursday that it provided £100mn to its DB pension.

DB schemes have fallen out of favour in recent years and are largely closed to new members. But even in the private pension market they remain sizeable. The DB pension scheme market is some £1.5tn, according to David Fogarty of consultancy Dalriada Trustees.

LDI products still have their defenders. BT’s pension scheme believes that without using this hedging strategy its own deficit would have doubled from £8bn to almost £15bn in the years from 2012 to 2020.

But every crisis tends to be followed by an equal and opposite regulatory reaction. The Financial Conduct Authority admitted to not testing for the specific scenario that occurred. The Pensions Regulator said that it lacked data on the use of leverage. Expect more investigations and regulation to follow. That suggests DB schemes may have to hold more risk-free capital buffers.

More buffers is likely to mean less hedging, particularly using leveraged derivatives. It could also mean there is less capital available for growth assets. Investment return assumptions may fall. Investors need to consider how many corporate sponsors may be underestimating deficits in their DB pension schemes.