Most defined benefit schemes represented at an event on Monday were able to keep their interest rate hedges intact during the recent market crunch, but more than a quarter don’t know yet. What are the lessons to be learnt from the past week? 

 

Pension schemes with liability-driven investment programmes were forced to post collateral at unprecedented levels between Friday and Wednesday last week, as the UK government’s plans for tax cuts and borrowing spooked markets on 23 September. The downward spiral in gilts prices was only interrupted by the Bank of England stepping in with unplanned quantitative easing until 14 October. 

 

At an event by consultancy XPS Pensions Group on Monday, it emerged that most pension funds coped with the challenging speed and size of collateral calls as gilt yields spiked. More than a third (37.4%) managed to source assets at short notice to top up their hedges, and a quarter of the roughly 700 attendees said they did not even need to top up. Only 3.6% said they had their hedge reduced because they could not source assets when collateral calls were made, and 5.3% had it reduced because the fund manager suspended trading. A sizeable proportion – 28.5% - did not know if their hedge had reduced. 

 

 

 

Simeon Willis, chief investment officer at XPS, said it was impossible to have full information on the overall effect on hedging levels from recent market swings. “My estimate is that many hundreds of schemes will have seen some level of trimming of their hedge through pooled investment,” he said. 

 

 

DB schemes in pooled LDI funds – often the smaller schemes – were perhaps most at risk. Simon Bentley, a managing director at Columbia Threadneedle Investments, contrasted segregated mandates and pooled funds, where the framework is more rigid and investors need to be treated equally. In segregated mandates, there is “more flexibility to change timeframes” and the manager has “line of sight of capital on its way”, he argued. 

 

The extreme movements of Monday and Tuesday last week meant “not only did we go through initial [capital] call points, but we were getting to a point that if [additional assets] hadn’t arrived, we would have had to reduce exposure for some clients”, he said.  

 

Bentley admitted there were a minority of cases where “a small amount of exposure” was taken off but said this is reinstated if the scheme is later able to source liquidity. “Once that capital subsequently arrives, that hedging is reinstated. We are going through that process now."

For schemes that did not have their hedges reinstated by last night, the impact could have been another hit to funding levels. Yields dropped back after chancellor Kwasi Kwarteng announced a U-turn on scrapping the 45% marginal tax rate and said he would outline the government's debt plans this month. He had originally wanted to do so on 23 November, but market reactions to the lack of clarity on how the UK will fund its spending spree could cause more upheaval if no plan is shown soon. 

 

Collateral buffers in portfolios “were adequate for the world we knew”, said Bentley, who stressed that last week’s yield movements went beyond what anyone had foreseen.  

 

A reduction of leverage – which is the direction of travel anyway as pension funds become better funded and derisk – will be a likely outcome of the recent events.  

 

Bentley also highlighted that if other assets were held with the same manager, these could be switched across easily to recapitalise hedges – but where assets were held elsewhere, lead times were “not appropriate in these circumstances”.  

 

This could be one of the lessons of last week, and lead to solutions that give the LDI manager a greater remit over other assets, to be able to move swiftly when collateral pools need to be topped up. 

 

The need for speed in stressed situations could also increase demand for fiduciary management and implemented management services, where the daily investment business is delegated by the trustees.  

 

However, fiduciary managers did not necessarily fare better. 

 

“We have seen some fiduciary managers, because of their choice of LDI manager, be caught by suspended trading. And some fiduciary managers with an increase in complexity and illiquid assets in the portfolio will have been unable or will have had more difficulty in meeting collateral calls,” said André Kerr, head of fiduciary management oversight at XPS. 

 

 

The fact many respondents to the event’s straw poll did not know if their hedge was reduced raises the question if communication has been adequate. Some schemes have complained about information not being available from their LDI manager, according to XPS. 

 

“The lack of information has contributed to people’s unease about where their scheme’s position is,” remarked Willis. The unusual market conditions created enormous pressure on client servicing teams, while yields were changing almost minute by minute, making it difficult to say what a scheme’s position was. 

 

"But some managers have been better than others,” Willis said. By now, good quality information on hedging should be available, he added, and “where it is not available that demonstrates cracks in the infrastructure of fund manager information [flows]”. 

 

Communication is not just important for asset managers – Neil Bull, investment consultant at the Pensions Regulator, stressed that no pension funds became insolvent, unlike what some reporting had suggested and some members of the public might believe. 

 

He pointed out that the regulator has been warning trustees about the need for stress-testing liquidity. As for how pension funds fared, “it was challenging, but the system coped”, Bull argued.