Surge in UK gilt yields exposes pension fund weaknesses

Low, not rising, yields were thought to be the danger

A decades long downward move in UK gilt yields has led to a fall in the interest rate used to discount future cashflows and increased the value of UK defined benefit pension fund liabilities. Many pension fund trustees, faced with the considerable risk that the value of assets held by funds would not increase commensurately, adopted liability driven investment strategies.

These LDI strategies involve purchases of repo or derivative contracts, with the aim of matching liabilities as closely as possible with minimal risk. Since the lowest risk assets are government bonds, which cannot be expected to produce the returns funds require, leverage has been employed. For example, one-quarter of a fund might be invested in LDI assets which, when scaled up, match all of the fund’s interest rate and inflation risks. The remaining three-quarters are invested in assets, such as equities to produce the desired investment return.

This leverage requires collateral to be posted against the repo or derivative contracts. While the collateral is likely to consist of investments such as short duration bonds and asset backed securities, it is gilts which will be sold if collateral calls cannot be met and leverage needs to be reduced. This means that when gilt prices are falling, collateral requirements may force gilts to be sold, further depressing prices. This risks a downward spiral and is the reason behind the Bank of England’s intervention on 28 September.

The solution of using other assets to boost collateral is not as simple as it might seem. These assets may not be accepted as collateral nor may they be readily monetised. For example, it has become ever more fashionable to hold ‘private’ unquoted assets, notably private equity, private debt and infrastructure investments. While exposure to such assets is carefully monitored with regard to anticipated negative cashflows in future years, not enough attention appears to have been paid to a potential immediate need for cash.

Smaller pension funds are especially vulnerable to these problems. They often use products sold by investment management companies, pooling their LDI assets with other pension funds. In this case, the investment management company cannot transfer money from elsewhere in the fund to increase the collateral and may instead need to decrease the leverage. Of course, this is not what pension funds want. Yet, they may have no control over the situation. From a manager’s perspective, an upward spiral in gilt yields could threaten this business.

Large pension funds can also suffer. Notably, the repo or other derivative contracts usually need to be rolled over quarterly, which may not be done easily in times of stress. Another issue for most UK pension funds is that the inflation protection offered to fund members is capped, typically at 3% or 5%. The result is that the extent to which the overall fund liabilities need to be hedged against inflation varies with the level of inflation.

It is clear that Bank of England intervention, potentially purchasing £65bn of gilts over 13 days, can do no more than buy time. The Bank’s monetary policy cannot be switched from the planned quantitative tightening to renewed quantitative easing to support pension funds. Pension funds themselves must change.

First, pension funds should be carrying out thorough scenario testing exercises and taking appropriate action. The UK pensions industry has had a mentality that the risks lay largely in the direction of lower yields. They believed higher yields were good as they reduced the value of liabilities, improving solvency. However, the issues which many pension funds faced last week have highlighted that higher yields can bring their own problems.

Second, an acceptance of lower returns with less leverage seems in order. Not for the first time, financial engineering has come unstuck due to implementation issues when the theory is taken too far. This is linked to the issue of collateral. Falls in gilt prices leading to collateral calls and subsequent forced sales of gilts are clearly unsatisfactory.

Lastly, a greater appreciation by pension funds that, while they may be very long term investors, problems can be very short term. For some funds, this may mean ensuring a greater commitment to liquid assets which can provide a buffer in times of need.

Pension funds do maintain risk registers, classifying a long list of risks by likelihood and severity of impact. Nevertheless, they may find regulators stepping in with restrictions unless they take more action to mitigate these threats.

Colin Robertson is Independent Adviser to a number of pension funds and former Global Head of Asset Allocation at Aon.

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