It has been a remarkable three weeks in the world of politics, economics, sterling and gilt markets and pensions with events from each sphere having a profound effect on all the others.
So, in considering how DB pensions ended up in the eye of the storm and provoking a Bank of England intervention in gilt markets, it is probably best to start with the politics and economics.
A ‘fiscal event’ unnerves markets
On Friday 23rd September, the new Chancellor Kwasi Kwarteng stood up in Parliament to announce significant tax cuts as part of a ‘fiscal event’ presented by the Treasury as the Growth Plan 2022. Despite the extent of the tax measures, it was not deemed a Budget and therefore not subject to accompanying fiscal calculations from the Office for Budget Responsibility something that would add to the ensuring controversy.
Kwarteng announced a rise in stamp duty thresholds with immediate effect, a reversal (in November 2022) of a rise in national insurance that had only been in force since April 2022, with more tax cuts for April 2023 including the abolition of the additional rate tax band, a cut in basic rate income tax of 1p and a cancellation of a planned steep increase in corporation tax from 19 to 25 per cent.
Many of these changes would inconvenience pension scheme administrators, but they were not exactly seen as an existential threat.
The tax changes came alongside a huge intervention in the energy market. An support packagecapped households’ unit costs for two years and for business and public service organisations for at least six months with a more targeted business package intended to replace it in spring.
Both sterling and gilts had already had a difficult summer, but the extent of borrowing planned without much evidence of how it would be paid jolted markets significantly.
Sterling immediately came under pressure falling at one stage close to $1.03 in early Monday morning trading and thus coming close to dollar parity. Over that weekend and into Monday, pressure increased on the gilt market with rates soaring. There were Bank of England reassurances on Monday 26th that it would not hesitate to intervene, but while that stemmed sterling’s fall, the gilt market remained under pressure.
It became increasingly clear that global markets expected the Bank of England to have to raise interest rates faster and higher with expectations of near or above 6 per cent base rates being required.
The first visible ‘real economy’ casualty was the mortgage market as product ranges were withdrawn swiftly and fixed rate offers reissued with significantly higher interest rates.
A problem for pension funds and a Bank of England intervention
By Wednesday 28th September however, it had become clear that DB pensions were another a weak link because of the pressures in the gilt market. Schemes were facing margin calls due to their liability driven investment strategies.
The Bank of England was forced to announce an intervention “to restore orderly market conditions,” with an intervention that could have reached as high a £65bn though such sums were not called upon. It did by and large calm gilt markets following the fiscal event panic.
Bank of England graph showing the course of 30-year gilt market moves around the fiscal event and its first intervention.
In one of several statements, it said: “The Bank stands ready to purchase conventional gilts with a residual maturity of more than 20 years in the secondary market, initially at a rate of up to £5 billion per auction.”
This week on October 11th, the scope of the intervention widened to include index-linked giltswhich had also faced disruption.
Yet broadly the Bank has sought to make clear that its intervention would end on the 14th October. In preparation for this, on the 10th October, the BoE had also set up a Temporary Expanded Collateral Repo Facility (TECRF) designed “to enable banks to help ease liquidity pressures facing their client LDI funds through liquidity insurance operations and accepting index linked gilts and corporate bond collateral”. This would extend beyond the 14th but would represent support for banks rather than direct gilt market intervention.
The gilt market and perhaps DB schemes are currently watching these developments nervously.
What happened with the LDI strategies?
There had been warnings and concerns raised about LDI strategies over several years including at times by The Pensions Regulator itself. But the extent of the shock surprised many.
TPR chief executive Charles Counsell has now provided an interesting assessment of the extent and structure of the LDI market and its view of what happened in response to questions from the Work and Pensions select committee chair and former pension minister Sir Stephen Timms. The letter was published by the committee earlier this week but looks back over the previous few weeks’ events.
£1.4 trillion liabilities covered – TPR’s view about the structure of LDI
In the letter, TPR outlined two types of LDI agreements:
- Pooled where investors club together, buy assets, and share in the returns like any other fund.
- Segregated where the LDI assets are bespoke and the funds or assets are specific to the pension scheme.
Counsell’s explanation continued: “At the end of 2018, there were around 2,400 LDI agreements. We expect this had grown to around 3,000 agreements by the end of 2021.
“Of [these] agreements, we expect about 60 per cent are in pooled funds and 40 per cent segregated. Given there are just over 5,000 DB schemes in the UK, this means about 60 per cent of pension schemes have LDI.
“When we consider assets under management (AUM) in DB schemes, our landscape analysis suggests around 85 per cent are in segregated LDI while around 15 per cent are in pooled agreements. In terms of the size of liability hedging in the leveraged LDI market, one LDI survey we studied indicated that the total level of liability hedging was just over £1trn at the end of 2018.
“We estimate that by the end of 2021, total hedging with LDI funds covered around £1.4trn of liabilities for DB pension schemes.”
TPR then outlined its view on schemes, advisers and LDI managers.
“Our view is that most trustees of DB schemes, their investment advisers, and LDI managers do think carefully about collateral requirements for their LDI funds, particularly the risk of gilt yields increasing. Generally, trustees will have pre-determined plans for the sources of collateral and how they will post collateral should the need arise. LDI managers typically work with a scenario of bond yields increasing by 1 per cent within a few days. The change experienced in September was twice this amount and came against a backdrop of long-term gilt yields rising by 2 per cent already in 2022.”
The LDI feedback loop
It also contains a neat summation of TPR’s view of the ‘feedback look’ in terms of gilts.
“At the end of September, counterparty banks asked for greater collateral (very significantly more than had been anticipated by the usual downside scenarios envisaged), and trustees of schemes/LDI managers found it challenging to source this liquidity at short notice. If additional collateral is not posted, or LDI managers decide to reduce their exposure, LDI managers begin to sell the LDI assets and sell gilts. However, the collective selling of gilts pushes the price of gilts down further, and increases gilt yields, further exacerbating the problem and creating a negative feedback loop.”
Finally, addressing the risk of schemes falling on to the PPF, TPR said it was reassured.
“We do not believe that the recent issues significantly increased the short-term risk of schemes entering the PPF. They have been clear in correspondence with us that they were not at risk, were well prepared (through prudent liquidity management and maintaining a healthy cash buffer) and managed to keep all their liabilities fully hedged without needing to sell assets.”
The public were less impressed of course with understandable fears about pension schemes raised in the media though some pension sector professionals have criticised some media reports. Others have blamed TPR for not getting on to the front foot in its communications with the public.
However, as the deadline for the withdrawal of the Bank’s support approached matters came to a head again as the Governor of the Bank of England Andrew Bailey and its chief economist Huw Pill reiterated that support for the gilt market would end this Friday 14th October.
On Tuesday 11th October, Bailey, speaking in Washington at the Institute of International Financeoffered the following rather remarkable statement: “We have announced that we will be out by the end of this week. We think the rebalancing must be done, and my message to the funds involved and all the firms involved managing those funds: You’ve got three days left now. You’ve got to get this done.”
This was essentially rejecting a plea from the Pensions and Lifetime Savings Association to extend support till October 31st.
XPS – no evidence of stability
XPS Pensions Group has provided an important commentary about the situation.
It observed (its description) that fund managers are currently taking an extremely cautious approach to capitalisation levels on LDI contracts, almost continuously updating their capital requirements to ensure that schemes are insulated from a 300-basis point (3 per cent) increase in gilt yields or what is describes as headroom.
It suggested that it has yet to see the position stabilise where the capital position is set such that gilt yields do not require additional funding.
It estimated that for every 50 bps (0.5 per cent) movement in gilt yields, £70bn of funding is needed to maintain the 300 bps ‘headroom’ at its existing level and suggested that pension schemes are still being driven to sell assets – primarily bonds but also equities and other assets – to cover the shortfall and maintain their hedges.
Although XPS doesn’t say so, the latter may be why some property funds have shuttered for example.
It finally suggested that the end of the Bank of England intervention could see gilt yields rise further.
Summing up Ben Gold, head of investment at XPS Pensions Group, said: “With volatility in gilt yields continuing, we see no evidence that the LDI market is likely to stabilise once the Bank of England ends its bond-buying programme, which it is due to do on Friday. With every 0.5% rise in yields driving £70bn in collateral calls to schemes with LDI contracts, the potential for continued disruption and significant levels of further asset sales in the market is high.
It is notable that several other important voices agree with the PLSA at time of writing including Ros Altmann, a former minister of state at the DWP under David Cameron, though her critique is a wider one.
In a blog post this week, she wrote: “It is vital that the central bank stands behind the gilt market for longer and puts quantitative tightening on hold, so that confidence in UK monetary and fiscal policies has a chance to recover. The present situation is dangerous for growth, damaging for pension schemes and could be disastrous for older pension savers who may already have lost a huge chunk of their retirement savings [referring to DC]. This emergency has not gone away and must be carefully managed.”
Of course, much of the story of the past three weeks has been one of worlds colliding in this case politics, the markets and pensions.
Deeply unsettled political picture
At time of writing, the Chancellor Kwasi Kwarteng has been sacked with tax U-turns expected from the Government. This had followed strident criticism this week from the Institute for Fiscal Studies among others which suggested cuts or tax rises of £62bn would be by 2026/27 necessary to square the fiscal circle and get debt falling in the medium term.
The UK has seen ratings agencies shifting the ‘outlook’ to negative (though short of a full downgrade) from ratings agencies Fitch and S&P with Moody’s threatening action soon.
Various current and former finance officials and politicians notably from the US and Germany had expressed concerns as has the global lender of last resort the IMF.
The IMF has been critical of the unfunded nature of UK tax cuts. It is also generally opposed to a universal support for energy but wants targeted support.
This week, IMF managing director Kristalina Georgieva said: “Our message to everybody, not just to the UK, at this time is fiscal policy should not undermine monetary policy because, if it does, the task of monetary policy only becomes harder and it translates into the necessity of even further increases of rates and tightening of financial conditions. So don’t prolong the pain.”
A Government promise for the OBR to publish its assessment of the public finances on October 31st also started to pile on the pressure.
Meanwhile global investment bank JP Morgan said the UK gilt market may be permanently scarredor in other words, the UK’s cost of borrowing may now be higher whatever action is taken.
Gold was not sounding too optimistic on Wednesday.
He said: “It is clear there is still a material risk that schemes will have to sell even more assets if they want to retain their liability hedges once the Bank of England’s support is removed. Without a clear mechanism to stabilise gilt yields, markets are going to continue to act out of an abundance of caution. The threat of systemic instability originating in the LDI market has not yet passed, and next week could continue to be incredibly difficult – both for pension schemes and the wider financial system.”
TPR has asked schemes to prepare for the end of the Bank’s deadline.
Significantly, however, even the talk across markets and media of tax U-turns had calmed gilt markets on Thursday and into Friday, which could conceivably smooth the passage of the Bank’s withdrawal of support.
What TPR is telling schemes to do this week
Managing investment and liquidity risk in the current economic climate 12th October
Operational processes —You should have robust procedures in place to help them respond to changing circumstances, make decisions and implement them where the need arises. Consideration should be given to whether adding one or more professional trustees would help in these circumstances.
Liquidity position — We expect trustees to discuss their current liquidity position with their advisers, including understanding their sources of liquidity, reviewing any liquidity waterfalls and topping up or increasing collateral where appropriate.
Liability hedging position — As part of reviewing their risk profile, trustees should consider the extent of their liability hedging position. This will already be a key consideration for schemes that have experienced liquidity difficulties but is an issue all schemes face in the current environment, particularly those that did not have a significant level of matching assets relative to liabilities.
Funding and risk position — While some schemes have experienced challenges in delivering collateral on accelerated timescales during recent events, and liquidity will be the main focus for many trustees, it is useful for all schemes to review their current funding positions in light of market changes.
Consider how current yields impact other areas of the scheme — Higher yields impact on transfer values and so trustees should monitor the appropriateness of the assumptions used in calculating transfer values and review the transfer value basis in light of this. Market volatility often presents opportunities for scams, and trustees should remain vigilant and follow best practice in this area.