The U.K. “mini-Budget”1 in September 2022 sent government bonds into a tailspin, unravelling the £1.6 trillion liability-driven investment (LDI) market resulting in major turbulence for U.K. (defined benefit) pension funds. The U.K. government has subsequently set to roll back on some of the commitments from the initial budget and even removed Kwasi Kwarteng as Chancellor of the Exchequer as it looked to regain the trust of the markets in its fiscal policy.
However, many questions linger about how and why the initial incident happened. The budget, which included tax cuts with little detail on how they would be funded, sparked a surge in volatility of U.K. interest rates and bond yields. This profoundly impacted many defined benefit (DB) and other pension schemes using LDI derivative strategies.2 These strategies hedge liabilities but, by their nature, face a huge uptick in margin and collateral for their derivative positions.
Ironically, many of these derivative positions were collateralized using long-dated U.K. government bonds (Gilts) which dropped materially in value following the market’s reaction to the budget. This in turn meant a gilts sell off which dropped the prices further and sent the gilts market into a downward spiral.
Due to their importance to the U.K. pension sector, the situation got to a point where the Bank of England (BOE) intervened with the promise of temporary gilt purchases up to £65 billion. The BOE intervention helped calm the market volatility across the board and subsequently some calming revisions have restored UK gilt prices and yields, as well as Sterling, to more normalized levels.
Much has been written about the actuarial reasons for the leveraged LDI strategies employed by pension funds but at its core the story is quite simple.
LDI worked perfectly for pension schemes while equity markets stayed relatively stable and interest rates stayed very low for an extended period of time. As such, it made sense and was relatively low risk to get the long-term bond exposure through derivatives while at the same time hedging (the minimal) interest rate risk. This then freed up more pension fund capital to invest in higher returning assets such as equities to meet their return expectations and requirements.
Since the turn of the millennium, the fall of longer dated gilt yields has been a costly head wind to all pension funds, so much so that pension schemes are largely now closed to new entrants due to the accounting value of their soaring liabilities. When bond yields fall, the present value of those future liabilities are discounted at a lower rate.
LDI as a concept works well in the conditions that have broadly prevailed for the last decade hence why they’ve grown to be a £1.6 trillion market. However, a seismic instant shock to base interest rates on any leveraged interest rate derivatives can have outsized impact on a portfolio. The recent margin and collateral calls in the falling market created a self-fulfilling prophecy of needing to sell off the very asset that was dropping in value and creating the cash requirements in the first place.
The specific issue of LDI leverage and risk management will undoubtedly come under further review. But the event poses the wider question around the very structure of pension investment structures in an increasingly volatile investment market, at the same time where pension funding needs are ever growing. The return of interest rates generally is helpful in the long term to pension funding requirements. However, it is also true that other methods of longer-term risk adjusted returns are required for pension schemes.
What’s the Alternative?
Pensions should perhaps seek longer term exposures which are less sensitive to interest rate (or other market cycle) shocks. Remember the genesis of the LDI fund market was pension exposure to high growth technology stocks which imploded when the “Dot Com” bubble burst.
One such solution for the U.K. pension schemes that is developing well is the Long Term Asset Fund (LTAF). The LTAF aims to provide the U.K. market with an open-ended fund structure that allows investment in long term less liquid asset classes while at the same time offering robust structural and governance safeguards.
The Financial Conduct Authority’s (FCA) recent launch of a public consultation3 on this topic is therefore both interesting and exciting. The consultation seeks to balance retail investors’ appetite for non-traditional investments and higher returns against the risk of such investors not fully understanding the illiquid nature and corresponding risk of the underlying assets. The proposals are important as they aim to make it easier for a wider audience of retail investors and pension savers to invest in the LTAF, thus making the vehicle more attractive to asset managers weighing up whether to launch an LTAF to raise assets.
The FCA previously lifted the 35% limit on pension scheme’s investment in LTAF-linked funds. The consultation proposes to extend the policy to self-selected options (e.g. if a pension scheme member opts for a non-default option invested in an LTAF, the 35% limit would not apply).
Another recent positive policy step to help the LTAF came in the shape of a move from the U.K. Department for Work and Pensions which stated that it would allow pension scheme trustees to scrap a cap on performance-based fees “where they feel this is in their members best interests”.
The cap has been one of the disincentives for asset managers to consider launching LTAFs as it made it commercially less attractive to do so. This long-standing charge cap on fees has typically stopped cash from flowing into asset classes like venture capital and private equity, where money managers charge higher fees due to a more ‘hands-on’ style of investment.
What does the Cap Removal Mean for Asset Managers?
In particular, the draft regulations would repeal the previous description of a ‘performance fee’ contained in Regulation 2(1) of the Charges and Governance Regulations. While these changes remain under consultation until November 10, 2022, they should apply to pension schemes and aide the construction of LTAFs and their underlying longer term asset classes. These changes are welcomed by the asset management industry and open wider investment opportunities for pension trustees.
For further information on the LTAF initiative, reach out to your BBH representative and follow the BBH Market Insights feed on LinkedIn where we will be posting more insights on this topic.
2 Under an LDI approach, a portion of a pension scheme's assets are invested to match the sensitivity of its liabilities to interest rates and inflation
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2022. All rights reserved. IS-08465-2022-10-21