Twenty-one years ago, John Ralfe, then in charge of the £2.3bn Boots pension scheme, took the momentous decision to sell all the fund’s £1bn of equities and invest solely in UK government bonds.
The advantages, he later explained, were that in doing so, he matched the assets of the fully funded defined-benefit scheme to its liabilities, reducing the risk for Boots’ management and shareholders of a future deficit that the company would have to make up. It also reduced the risk for the 72,000 members, lowered investment costs by 97% and, by selling early in the bear market, avoided large equity losses.
Liability-driven investment (LDI) was born and other companies rushed to follow suit, especially those that were fully funded and closed to new employees. New staff were instead offered defined-contribution schemes in which they, not the company, took the investment risk. Companies found an added attraction in that having matched assets to liabilities, they could offload responsibility for the scheme entirely to asset managers such as Legal & General. They earned well from selling LDI.
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Gearing up with derivatives
Sceptics noted that without knowing how long the members would live, matching assets to liabilities was an actuarial estimate, not a certainty. More importantly, there weren’t enough long-dated gilts to match the liabilities, so it was just assumed that the proceeds from maturing gilts could be reinvested at the same yield. If yields fell, as they did until 2021, a gap between assets and liabilities would open up and the scheme could become underfunded.
Nevertheless, so popular did LDI become that sponsors extended it to underfunded schemes. The cunning plan (in the Blackadder sense of the phrase) was to invest not in physical gilts but in “swaps” – derivative contracts giving artificial exposure to the gilt market through financial counter-parties such as investment banks. The advantage of this was that even with the required collateral, much less capital needed to be invested, thereby freeing capital to be invested in other assets in an attempt to catch up on the shortfall.
In effect, this meant leverage (ie, borrowing) as the gross exposure to investments was higher (potentially a multiple of) than the asset base. This was fine so long as gilt yields fell and the swaps generated profits, so the success of the model led to it expanding to cover £1.5trn of assets. The switch into LDI is likely to have driven gilt yields to unsustainable lows (0.68% for ten years at the end of 2021) and the selling of UK equities may have depressed valuations.
LDI funds took on more risk than they thought
Simon Wolfson, CEO of Next, not only refused to switch the Next scheme to LDI but wrote to the Bank of England in 2017 that LDI strategies “always looked like a time bomb waiting to go off”. The Bank of England cannot say it wasn’t warned.
Wolfson’s view that LDI funds “are actually taking a lot more risk than they thought they were” has been borne out as gilt yields have risen. The ten-year gilt yield reached 2% in May, 3% in early September and broke 4% as Kwasi Kwarteng announced his poorly-timed mini-budget. It peaked at 4.5%.
The crash in bond markets was a global phenomenon but was exacerbated in the UK not by the mini-budget but by an avalanche of selling by LDI schemes. As gilt yields jumped and the losses on their swap contracts mounted, they were forced to sell what physical gilts they had in order to provide more collateral, and the sell-off turned into a rout.
The Bank of England stepped in with a pledge to restart quantitative easing and buy up to £65bn of gilts to stabilise the market. Ten-year yields have since fallen back below 4%. But the crisis is far from over.
Gilt yields won't return to huge overvaluation
Firstly, the liquidity provided by the Bank of England increases the money supply and will filter through into higher inflation and hence higher gilt yields.
Secondly, the LDI schemes in trouble may have been able to put up collateral and hence avoid insolvency, but the losses remain. It is inconceivable that gilt yields will return to 2% let alone 1%, and even 3% is an optimistic target, requiring inflation to return sustainably to 2%. Bond markets in general and gilt yields in particular are extremely unlikely to ever return to massive overvaluation.
So what can the managers of all those schemes that are under water do? They have a series of unpalatable choices. They can admit that the LDI scheme has failed and go cap in hand to the government for a bailout. They can seek to reduce the benefits to members for which they are contractually liable. They can seek to pass the scheme on to the already overstretched Pension Protection Fund. Or they can seek to make up the shortfall by switching the fund to invest in supposedly higher-risk, higher-return assets such as equities.
As architects of yet another mis-selling scandal, they and their companies can expect no mercy from the media, the regulators, the government, public opinion or, perhaps, the courts. As one shrewd observer points out, “all the mis-selling scandals have come about from those who claim to be reducing risk actually doing the opposite”.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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