Rising yields have pushed up the borrowing costs for pension funds with liability-driven investment. As a result, they had to post collateral, often selling growth assets while equity markets were down. Do trustees need to worry about their fund’s liquidity? 

 

The large LDI managers – BlackRock, Legal & General Investment Management and Insight Investment – have issued calls to shore up LDI exposures with collateral as yields have risen and even spiked last month. Some pension funds have sold growth assets in a down market to meet these capital calls. Does that mean they are under pressure? 

 

 

David Blake, director of the Pensions Institute at Bayes Business School, said that LDI is “the appropriate strategy for meeting DB obligations” because the assets – which are mainly bonds – are chosen so that the cash inflows on the assets match the cash outflows on pensions in the short term and have the same duration as the liabilities. This means when interest rates change, the value of the assets and liabilities rise and fall in tandem so that surpluses and deficits do not emerge. 

 

High yields do not cause an issue if the strategy is followed exactly, he said. “There is only a problem if there is a duration mismatch so that asset and liability values change at different rates when bond yields change,” he explained. 

 

Pension professionals seem unconvinced that collateral calls will create liquidity constraints for funds. Doug Heron, the chief executive of the CERN Pension Fund, said the purpose of LDI is to lower scheme risk. 

 

“The recent rise in yields should present no major concerns for most pension funds, particularly as self-sufficiency liabilities will be falling,” he said. “Those with leverage in their LDI strategies will presumably have well-developed stress testing protocols and can quickly implement plans to adjust to the higher yields which are hardly a surprise.” 

 

Pension schemes will hold a prudent buffer to ensure they can meet collateral calls, said Jos Vermeulen, head of solution design at Insight Investment. These buffers have generally fallen as interest rates have increased, but the requirement to top them up will depend on a number of scheme-specific factors, he noted, including the size of the starting collateral buffer, the duration of the liabilities and the level of inflation-linkage in the liabilities. 

  

Trustees should have plans to maintain their buffers in case rates continue to increase and further top-ups are required, he said, as well as consider the liquidity profile of their assets and ensure they have the governance to move assets between different pots. 

 

“Risk management is not about speculating whether rates will go up or down, but about ensuring that the scheme can cope regardless of the outcome. That’s why we recommend stress testing and pre-planning,” Vermeulen said. While hedging removes the risk of having to guess the direction of rate movements, it requires that other risks – such as counterparty risk and liquidity or collateral risk – are being managed. 

 

 

The Pensions Regulator expects trustees to monitor their scheme’s investment, risk management and funding arrangements on an ongoing basis. Where there have been significant market movements – including in interest rates and inflation – “we would expect trustees to review with their advisers the resilience of their investment, risk management and funding arrangements in more detail”, a spokesperson said. 

   

Where schemes are allowing higher levels of leverage than previously, TPR expects trustees to understand the collateral implications of that change and “develop, with support from their advisers, a robust liquidity waterfall structure for their collateral requirements”, the spokesperson said. 

 

“More generally, where trustees are using highly leveraged hedging solutions, we would expect them to fully understand how collateral requirements might be met in practice and the implications for their scheme’s investment and risk management arrangements if they are not able to meet those requirements,” the spokesperson added.   

 

 

While a small number of funds might be more nervous, “most have plans in place to meet calls”, said Mark Minnis, head of LDI research at consultancy XPS Pensions Group, having calculated beforehand whether they have enough liquidity if interest rates rise and where they would sell from.  

 

Funds use cash or sell growth assets to meet capital calls, but “it’s not necessarily a bad thing to sell growth assets”, Minnis argued. As yields rise and bond prices fall, a fund’s matching portfolio shrinks in relation to the growth portfolio, where the fund becomes overweight. “A capital call rebalances that,” he said.  

 

With stock markets down, funds selling growth assets will however be crystallising losses. “There's a bit of an issue that growth assets are falling at same time as gilts,” admitted Minnis but added that most funds have “enough room” to absorb losses, either thanks to a high funding level or high expected returns. 

 

Despite many funds facing capital calls and having to sell growth assets, Minnis said trustees have not lost too much faith in LDI as they have seen its benefits in the past. “Now it’s not going so well that is just part of the plan. It’s just a slightly different side of it,” he said.  

 

Minnis said more clarity is needed about the size of the market. “It’s good for all stakeholders to get a sense of the size of the market, how much of the liabilities are hedged,” he said, noting that XPS used to run surveys with asset managers in the past but that one LDI manager changed its policy and stopped providing information. 

 

“It’s been very profitable business for [LDI managers] over the past few years,” but “as yields are rising their income has fallen”, he noted, because the size of the assets has shrunk. Despite LDI managers likely having lower income this year, Minnis does not expect any to downsize given that still more defined benefit schemes will reach maturity and have to match cash flows for a few more years to come. 

 

How well are pension schemes coping with the increase in collateral calls? 

 

Doug Heron