John Ralfe is an independent pension consultant.
The dust is still settling on last year’s LDI debacle, when the UK’s £1.5trn defined benefit pension system seemed to be in a meltdown triggered by September’s “mini”-Budget, and was saved only by the Bank of England’s intervention to buy gilts.
The regulators — the Bank, the Pensions Regulator and the FCA — and the Treasury are all trying to figure out exactly what happened, and make sure it doesn’t happen again.
The Work and Pensions Committee is leading the parliamentary investigation, hearing evidence from experts (including me). The most jaw-dropping evidence so far came from the partner of the head of Lloyds Bank Pensions, who spilled the LBG beans — a “clear breach of confidentiality” according to the trade union.
At its latest session the WPSC heard from Sarah Breeden, of the Bank of England, that it is working on new “steady state” resilience plans for LDI.
What lessons can we start to draw?
First, there is a world of difference between Liability Driven Investment and “Leveraged LDI” — and it is the latter, not plain LDI, which caused the problems.
LDI is just jargon for matching pension assets and liabilities, exactly what Boots pioneered 20 years ago. As well as switching from equities to long-dated bonds, including index-linked, this also involves interest rate swaps to receive regular index-linked payments.
Hedging reduces risk for scheme members, the sponsoring company, the Pension Protection Fund — which pays out if a sponsor goes bust — and the whole financial system.
But with “Leveraged LDI”, a pension scheme is effectively borrowing to buy assets which don’t match liabilities — equities, PE, hedge funds, property — betting their value will increase more than the value of liabilities.
The Bank of England Deputy Governor, Sam Woods, recently told the Treasury select committee:
[T]here is a bit of having your cake and eating it: you keep the returns from the higher returning assets you have and you leverage for the gilts part that you need for matching purposes. Q311
With Andrew Bailey, the Bank Governor, adding:
[W]hat started as a means of managing asset liability positions became a means of actually increasing the return to the fund . . . that is the leverage point. Q314
First things first: unlike LDI — hedging — “Leveraged LDI” is speculation, increasing risk for members, the sponsor, the PPF, and the whole financial system (see my earlier Alphaville on BT’s Leveraged LDI).
Second, leverage was hidden from members, shareholders, and bondholders, because accounting requirements are poor — pension schemes and companies don’t have to disclose details of their Leveraged LDI.
And, at best, the different regulators had only partial information on the extent of Leveraged LDI for individual schemes, and for the whole financial system.
How many trustee boards really understand the risks they are taking in opaque, complex and expensive Leveraged LDI? This isn’t solved by more ‘professional’ trustees: we need trustees asking the stupid questions.
Third, despite some claims, pension schemes don’t have to be leveraged.
Investment consultant Rod Goodyer told the Work & Pensions Select Committee:
DB pension schemes are forced, by their very construction, to mismatch assets and liabilities. There is therefore a tension between managing asset/liability mismatch (i.e. buying gilts to match liabilities) and generating the returns required in the funding plan to meet benefits in full. This is the reason why leveraged LDI was invented.
The claim that Leveraged LDI “was invented” to make sure pensions can be paid is extraordinary. Schemes are not “forced” to mismatch assets and liabilities, they can simply choose to hold long-dated bonds.
The LDI model does not necessitate leverage; it is a way of managing the assets and liabilities of pension funds. But it has become more leveraged over time. Q279
Companies are on the hook to pay pension deficits. If they want to bet their own balance sheet, that’s between them and their shareholders and bondholders, but don’t do it with pension scheme money.
The Leveraged LDI debacle was much more than just a problem in the financial “plumbing”, to be solved with a few technical tweaks.
What should happen now?
Some people — including me — have called for pension schemes to be banned from using Leveraged LDI. After all, they are banned from borrowing, but can use this leverage, with derivatives, to get round the ban. And Leveraged LDI has led to “moral hazard” on a grand scale, with taxpayers underwriting the consequences.
But rather than an outright legal ban — not easy to draft and enforce without unintended consequences — we can achieve a “soft” ban easily and quickly, through tougher supervision by the Pensions Regulator, and more transparent accounting for schemes and sponsors.
The Pensions Regulator should introduce regular, detailed scrutiny of all Leveraged LDI. Trustees would have to show they really understood what they were doing, and had systems in place to react quickly to any liquidity problems, including a formal credit line from the sponsor (some companies have done this already).
The IASB and the UK FRC should require pension schemes and companies to clearly disclose any Leveraged LDI in their accounts, including “uncovered” or “naked” interest rate swaps, leveraged gilt repos, and leveraged gilt funds.
There is already anecdotal evidence smaller schemes are cutting back on Leveraged LDI. Having to answer awkward questions from the Pensions Regulator, scheme members, shareholders and bondholders will see all Leveraged LDI shrinking (perhaps dramatically?).
Investment consultants who make a good living from Leveraged LDI (“the villains of the piece”, as I told the WPSC) will certainly lose out, as well as Leveraged gilt fund managers, including LGIM and BlackRock, and those selling gilt repos and interest rate swaps.
Alphaville veterans will know leverage always ends in tears, and no one should be surprised that it has happened to Leveraged LDI.