No free lunch in LDI, warns L&G boss
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The chair of insurance and investment giant Legal & General has warned building greater protection into liability-driven investment portfolios will come at a cost to pension funds and sponsors. He suggested lowering leverage and expanding the type of collateral as key solutions.
“There is no free lunch here. The more protection there is in the system, the greater the cost to pension funds and their sponsors,” Sir John Kingman, who chairs L&G, told the Lords Industry and Regulators Committee on Wednesday.
The investment strategy has come under the spotlight of politicians because a liquidity crisis developed when gilt markets reacted with extreme swings to Liz Truss and Kwasi Kwarteng’s proposals of unfunded tax cuts on 23 September, causing problems for defined benefit schemes and LDI funds.
No one expected a government ‘willing’ to crash its own debt market
Sir John explained that no one in financial services had stress-tested a scenario where the British government would be “willing to create massive instability” in its own sovereign debt market by announcing deep unfunded tax cuts that rely on borrowing – going in the opposite direction of its central bank, which just a day earlier had said it would begin monetary tightening.
Even if more extreme scenarios are tested from now on, this does not mean portfolios will be safe from their impact. Sir John said judgments will have to be made about how much risk to protect against.
At the moment, LDI is very well insulated from extreme scenarios as industry agreed it would, so that funds could withstand being weaned off central bank support. However, there is now a question about “where to put yourself on the spectrum” of risk between where things were before the crisis and where they are now, he suggested.
“It’s extremely unlikely anyone would just go back to where we were. But as you take yourself up the level of protection, you drive up cost, so there is some balance to be found,” he said.
Leverage and collateral in focus
Sir John argued that LDI has created enormous value for pension funds and sponsors but admitted there are lessons to be learnt to avoid a repeat of late September. Allowing a greater range of assets to be posted as collateral and potentially reducing leverage were two steps he suggested should be explored.
“We all need to reflect on these events, and some of those things will be quite practical things, for example the forms of collateral, then the simple question of how much leverage pension funds should operate,” he said.
L&G’s chief executive, Sir Nigel Wilson, told the committee that leverage was a useful tool but had to be taken in a duration context.
“The more volatility and the more duration, the more of a safety net you need... The good news is of course that DB schemes themselves are diminishing in duration every year and more of them are moving elsewhere” through buyouts, he said.
However, “the evidence suggests that actually we are going to live in a more volatile world and therefore we need to reconsider the modelling”, he added.
Do we need a resolution regime for non-banks?
Aside from the scale of leverage and the type of permissible collateral, another question arising from the latest crisis is whether there should be a resolution regime for non-banks. A resolution regime regulates what happens when certain financial institutions fail.
The issue is on the Financial Conduct Authority’s agenda, and Sir John noted that L&G will want to be part of the conversation about any new regime. He added it was “very understandable” that the authorities would want to create a mechanism whereby funds can fail without endangering the system. “It’s hugely technical, and we haven’t worked through what the answer might be.”
Sir Nigel said there was also a question about who regulates LDI.
“There needs to be some clarity around who would be the principal regulator for this particular part of the pensions industry,” he said. “Ultimately, I think it does go back to the Bank of England.”
Do you agree that lower leverage, a wider range of collateral, a resolution regime for non-banks and clarity about regulatory responsibility over LDI are the main changes that should be made?
