The period following the UK’s ‘Mini Budget’ has been a tricky one for some defined benefit (DB) pension schemes.
In the first of our series of articles on the impact of recent gilt market volatility, we considered the effect on pension schemes’ positioning in terms of full buyout with an insurer. In this article, we take a look at how a DB master trust could potentially help smaller schemes in times of market volatility.
Intervention from the Bank of England, a change in government policy, and the passage of time have brought some relative calm to financial markets, allowing schemes and liability-driven investment (LDI) funds to reorganise their portfolio positions. At the time of writing, the yield on index-linked 20-year government debt sat at around 0.3%, down materially from the 27 September intra-day high of 2.1%.
Now that the ‘firefighting’ phase seems to be over, we start to consider the longer-term impact of recent events on investment strategy. The focus of this article is investment governance – and whether a DB master trust might provide a solution for some schemes.
Leverage, LDI and a volatile market – a recap
DB pension liabilities are calculated as the present value of a series of benefit cashflows, typically referencing gilt yields. With significant movements in gilt yields over the last couple of months, shown in Figure 1 below, the value of DB pension liabilities has been extremely volatile.
Figure 1: 20-Year Inflation-Linked Gilts Intra-Day Yields
Most DB pension schemes in the UK have previously taken a view that liability volatility arising in movements in the gilt market is not a risk worth running.
In order to mitigate this risk, they invest in LDI strategies which are predominantly investments in gilts. This means the scheme assets move more in sync with the short-term gyrations of the liabilities. The use of leverage within these LDI strategies frees up other assets to deliver a return and help bridge scheme funding deficits.
However, leverage introduces a new risk into pension schemes, particularly in a rising yield environment. In order to achieve the additional gilt exposure, LDI funds borrow money using the gilts as security. These positions are collateralised, which means the amount of security the lender can call on will fall in a rising yield environment and will therefore need to be topped up.
The 'Mini Budget'
Following the ‘Mini Budget’ gilts sold off aggressively as investors worried about the UK’s finances. The price of gilts fell, resulting in the collateral pool available to LDI managers becoming exhausted. The so-called ‘doom-loop’ emerged, where managers were forced to sell positions due to lack of immediate collateral, exacerbating the fall in the value of gilts, resulting in even more collateral calls.
...some pension schemes struggled to source liquidity, putting the reliability of a key risk management tool against a future fall in yields into question.
In the circumstances where the immediate collateral pool is being run down, there is a re-capitalisation event where schemes are asked to provide capital from their other assets to top up LDI funds. Timescales vary between asset managers but typically 5 to 7 days’ notice might be provided, giving time to instruct redemptions from other investments. What made the post-Mini Budget days so different was the speed at which events where happening. Time constraints disrupted various lines of communication (from LDI manager to adviser to client to manager of other assets). Therefore, some pension schemes struggled to source liquidity, putting into question the reliability of a key risk management tool against a future fall in yields.
LDI still has an important part to play in the risk management of pension schemes. During the prolonged period of falling yields, it's helped mitigate the risk of increasing deficits for many pension schemes. However, what we can expect is a reduction and diversification of leverage for the future, with potentially shorter recapitalisation windows.
Investment governance under the spotlight
The significant intra-day moves in the market and acceleration of collateral calls seen recently pose the question: do pension schemes have the governance models in place for quick decision-making and implementation?
For companies and organisations that don't have the resources to continually be at the beck and call of their DB pension scheme, a master trust could help provide a solution.
Some master trusts have a single asset manager, professional trustee and single consultancy covering all advice.
Investment and funding strategies can be designed in preparation for future collateral calls. With liquidity waterfalls identified in advance, requests for cash can be met with pace.
A partnership approach between a common trustee, consultant and manager provides shorter communication lines and improved information sharing – time for resolution and implementation.
Well-defined delegation of roles and responsibilities can reduce the complexity and time of transition between mandates.
Ultimately, for a scheme with 50 separate sections all using the same manager for their LDI solution, there's one communication between one manager and one investment consultant and single trustee board. The scale of operation brings importance and simplicity.