Defined benefit pension fund portfolios have changed since last autumn, either through market valuations or active redesign. Experts look back to the liability-driven investment crisis of 2022. 

 

More than a year after the ‘Mini-Budget’ of former Prime Minister Liz Truss and her chancellor Kwasi Kwarteng sent gilt yields soaring, the longer-term effects of the event can now be seen in a clearer light. 

 

As a result of last year’s gilts crisis, pension funds generally ended up in one of three categories, said Paul Watson, a professional trustee at Capital Cranfield.

 

There were “those with very low levels of hedging that saw a rapid fall in the value of liabilities and could now be quite close to buyout”, he said speaking at a webinar organised by consultancy XPS Pensions Group on Monday. These tend to be buying gilts and adding some hedging now, he added.

 

"We saw quite an increase in smaller schemes adding hedging, perhaps because it was lower to start with,” he remarked. 

 

Other schemes already had LDI; about three-quarters of these held on to their hedging levels, having had some difficult conversations around how to do that and transitioning assets to meet collateral calls. 

 

And then, “there is about a quarter of schemes that lost some hedging on the way. That could have quite a material impact on the funding position,” he said. 

 

 

DB pension funds have shifted their assets after last autumn, adapting to the new environment. 

They might have put in some redemption requests for illiquid assets to get back down to their target weight as the market value of other assets has fallen, or they might even be redeeming them in full if they are close to buyout.  

 

However, doing so can be tricky if the assets are held in a closed-ended fund. In that situation, schemes will be looking at the secondaries market, said Watson, but noted that this can also be difficult as they are forced sellers and might therefore have to accept at least 20% off the net asset value. For large pension schemes that plan to run on for a long time, now could be a buying opportunity of such secondaries, he noted.

 

As funds have deleveraged, they hold more physical gilts, which in turn reduces their ability to gain exposure to growth assets that they might still rely on if the return target is unchanged. 

 

In that case, “the only way you can achieve your return target potentially is using the leverage in your equities”, said Watson. 

 

Trustees are considering using synthetic equities or structured options to get growth exposure, and he argued that “in the equity space we don’t see the same systemic risk as using leverage in long gilts”. 

 

Exacerbating the crisis from a pension scheme point of view were high levels of leverage and operational inefficiencies. The latter could be addressed by appointing a fiduciary manager, but Watson said he was “surprised we haven’t seen a greater move to fiduciary management” to achieve this. 

 

This might not be such a surprise when looking at the costs – Mark Minnis, head of LDI research at XPS, said some fiduciary managers raised their fees by as much as 25%. Meanwhile, LDI managers have tended to keep their fee structure unchanged, he found. 

 

One thing that might have changed, though, is how trustees view certain asset managers. Many trustees of pension schemes invested in pooled funds were left frustrated at the lack of flexibility these offered. Watson said pooled funds offered less visibility, saying he “came out [of the crisis] with a preference for segregated accounts”.  

 

Whether pooled or segregated, what happened last year is remembered. Watson recalled “those managers that cut hedging positions even when collateral was readily available”, an experience he said put trustee boards in a very difficult position. 

 

 

A repeat of the gilts crisis is unlikely, believes Simeon Willis, XPS chief investment officer, because avoiding this happening is a high priority for regulators. They have already addressed some of the issues, such as raising cash buffer requirements. 

 

The Bank of England is also currently designing a new lending tool for schemes, announced its executive director for markets Andrew Hauser last week, in a bid to address systemic risk and improve the resilience of the LDI industry. Under the proposed model, the central bank would act as a lender of last resort, which could help prevent managers from unilaterally reducing schemes’ hedges. 

 

Despite these additional safeguards, capital markets have not simply reverted to pre-crisis mode. Willis pointed out that volatility in gilts remains, as yields rose 0.4% in the space of a week in August this year, and that “politicians have a habit of doing surprising things”.  

 

While any announcement of unfunded tax cuts would not create the vicious circle it did last year, “we could well see politics driving the market in unusual ways”, he said. 

 

A general election is expected in 2024, and investors are having to second-guess not just the election outcome but also how the market will react to it. 

 

As politics remains unpredictable, so does the future issuance of gilts, and demand for these as the UK's DB pension funds buy out. Willis said he was concerned about the demand and supply of long-dated gilts, and advised “to remind ourselves, it’s not all about the bank rates”.