29 November 2022

Irish Funds Briefing paper on LDI and recent market events

LDI strategies have worked well for UK DB pension schemes for over 20 years, bringing stability to schemes’ funding ratios. By stabilising the funding ratio of a scheme, the scheme sponsor benefits from more predictable funding costs.

Irish Funds (IF) and its member organisations are pleased to offer this paper as a contribution to the discussions surrounding the recent volatility in the UK gilts market, and the subsequent impact on liability-driven investment (LDI) funds used by defined benefit (DB) pension schemes to manage risk.
In this paper we explain LDI and its historical role in helping UK DB schemes manage risk; offer an overview of what happened in gilt markets and the implications for pension schemes; describe how trustees, investment consultants, asset managers, regulators and the Bank of England (BoE) worked closely and constructively through the period; and explain how pension scheme and LDI strategies are adapting following the turmoil.

We would like to highlight the following points:
• LDI strategies have worked well for UK DB pension schemes for over 20 years, bringing stability to schemes’ funding ratios. By stabilising the funding ratio of a scheme, the scheme sponsor benefits from more predictable funding costs. Many LDI strategies use some leverage, which releases capital to acquire other investments that pay a premium over gilts. For less well funded schemes, without using leverage, the burden of closing a deficit would shift to their corporate sponsors, and members benefits would likely be less secure. Given this, there is a role for prudent management using higher leverage temporarily in some circumstances: for example, to avoid managers being compelled to reduce hedges when pension schemes will be able to provide collateral within a short timeframe.
• The market movements in September 2022 were unprecedented and exceeded the typical stress tests applied by pension schemes, their advisers, asset managers and regulators. After the UK ‘mini-budget’ on 23 September, there was unprecedented volatility in the UK gilt market. The fall in gilt prices presented pension schemes with large collateral calls, which led to rapid rebalancing of wider pension scheme portfolios, exacerbating volatility in the gilt market. We would therefore characterise the recent experience as a collateral challenge for pension schemes, not a pension scheme solvency challenge. To note, although individual schemes’ experiences may vary, recent data suggests the overall funding level of UK DB pension schemes has improved.
• Amid the market turbulence, LDI managers acted quickly, working with consultants, clients, administrators brokers and depositories to recapitalise collateral pools within LDI portfolios to appropriate levels, with close engagement with the Central Bank of Ireland (CBI).
• The recent experience has highlighted potential enhancements for pension schemes, their approach to LDI, and for LDI strategies. In some cases, changes have already been made, or are under way, to reflect lessons learned from recent events. These include:
- Reduced leverage in LDI portfolios
- Review of collateral eligibility
- Potential review of liquidity in pension scheme portfolios
- Potential review of pension scheme governance processes

Irish Funds

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