As one crisis is over, there are growing fears that the pensions industry could unwittingly slip into another.
The end of the world was near a few weeks ago. In the wake of warnings of a “material threat to UK financial stability” due to a run on UK pension schemes, the Bank of England was forced to intervene. This is similar to the situation facing Northern Rock in 2008’s collapse.
The crisis has been widely blamed on liability-driven investments (LDIs), which have been a key pillar of the pension investment strategy for the past two decades.
Experts fear that the “demonization” of LDIs could have devastating consequences for both pension trustees as well as company boards. They warn that trading out of LDIs could leave hundreds of UK final-salary pension schemes in deficit.
The fallout could also affect corporate growth, just as Britain is heading towards a recession.
“If companies and pension plans stop using LDI for controlling and fixing their deficits, there is a real danger that they will be forced to divert money away from the business, depending on the market movements,” states Dawid Konotey-Ahulu. He claims to have created the first LDI while working as an investment banker for Merrill Lynch over 20 years ago.
LDIs can be extremely complicated. However, they are based on a simple principle: fund managers can borrow against investments they already have to increase their returns and close funding gaps that opened up since the beginning of the millennium.
Critics claim that this has created a “timebomb in Britain’s financial system. However, supporters claim that this was a legitimate risk management tool. LDIs enable pension funds to swap higher-risk equity investments for bonds, allowing assets to be more closely matched to retirement obligations. Lower interest rates mean higher liabilities, but greater asset value.
The Pension Protection Fund (PPF), which oversees approximately 5,000 UK schemes, estimates that 750 are in deficit.
Pension fund trustees and managers are under pressure due to fears of a repeat of the recent run against LDI strategies. Many are faced with a tough decision: trade out of LDIs completely or opt for more aggressive investment strategies that require substantially more capital.
Lane, Clark & Peacock (LCP) states that trading out of LDIs is not an option. The LCP surveyed 400 trustees and company representatives in March. 90% of them said that LDI strategies would continue to be a part of their business.
Steve Hodder, a partner in the consultancy, said that there was “clear recognition” that LDI strategies would need to evolve for the current environment.
Konotey-Ahulu states that reducing LDI investments will have serious consequences. This will likely mean that companies will need to inject more capital into retirement funds.
He says that LDI is a highly efficient way to stabilize and repair a pension system’s deficit. This means that companies don’t have to worry about making additional contributions to the pension scheme, instead of investing in growth or dividends.
The estimated 750 pension plans that are insolvent may feel they have lost the chance to make a surplus of a deficit.
The British pension system was in disarray in the early 2000s. Labour’s Gordon Brown and Tony Blair introduced new laws that required company boards to examine their retirement obligations with greater care. For the first time, pension deficits were “brought onto the balance sheet”.
LCP stated that the FTSE 100 combined deficit was £55bn by 2003. Watson Wyatt was a pension advisor to many of the UK’s largest companies. However, Watson Wyatt had a large hole in its retirement fund.
According to the latest analysis by the consultancy, the FTSE 100 shows that blue-chip companies now have a combined surplus of £160bn.
Chief executive of one the City’s largest institutional money managers said: “You must remember, LDIs did a tremendous amount of good as demonstrated by the current health of UK pension funds.”
“When you compare how the UK’s pension funds have performed to other countries, like the US,” said the UK.
However, most LDI proponents did not envision a collapse of the bond market following Kwasi Kwarteng’s now-hastily reversed mini-Budget.
One senior City source says, “The truth is that we had more significant moves in those three weeks than in the history of our gilt market.”
Konotey-Ahulu states: “LDI is about driving UK growth by allowing businesses to focus on core business, leaving pension plans to stabilize their deficits and reach full funding over a few years.
“There are many lessons to be learned and areas for improvement, but the demonization of LDI over the past few weeks was deeply regrettable. It is possible that pension schemes will lose the protection they need.