It’s finally happened. Around 20 years since the dawn of liability driven investment (LDI), the hypothetical question that has plagued many pension trustee discussions on whether/how much to invest in LDI - “what happens when rates rise rapidly, could we run out of collateral?” - has finally become a reality.
With thanks to the current discord between the Bank of England (BoE) and Government, we are experiencing surges in gilt yields that haven’t been seen before. With the Government making tax cuts to ease the cost of living crisis, the market is assuming the supply of gilts needs to increase significantly to fund it. Overseas investors have low or no confidence in the UK economy and therefore no appetite to invest. Gilts are going cheap for the first time in nearly 20 years.
What does this mean for defined benefit (DB) pension scheme trustees?
Well, for many, the last couple of weeks may have felt like whack-a-mole of cash calls – repeated collateral calls on LDI portfolios, perhaps capital calls on an illiquid investment adding to the stress, as well as the raison d’etre of the pension scheme itself, providing the cash to pay benefits.
In this day and age, there’s a smorgasbord of governance models for pension trustees to consider. How have these fared when put through the current market’s extreme stress?
Trustee boards who opted to go down the fiduciary management route may be feeling calmer, having delegated the allocation and day-to-day management of the entire asset portfolio. Whilst fiduciary managers will be able to respond quickly to ensure there’s sufficient collateral and liquidity in the portfolio, there should be an enhanced level of diligence by pension trustees to review:
We also need to remember fiduciary management can be significantly more expensive than more traditional governance models. So whilst pension trustees with fiduciary managers are still sleeping at night, they are paying for the privilege.
The majority of DB pension schemes still operate within the advisory model, so what are the governance hacks that can help navigate the current economic drama?
Ideally, when trustees first invested in LDI, a plan would have been made of where additional collateral could be sourced from when needed. Typically, this starts with the most liquid, lowest returning assets, moving through the liquidity spectrum as more cash is required. A situation like this only highlights the necessity of making a plan and maintaining it, to reflect the trustee board’s evolving investment strategy so it can be implemented quickly and dispassionately, whilst ensuring sufficient cash remains to pay benefits.
A strong working relationship between pension trustees and their investment adviser is an absolute must. Clear lines of communication are key given the need to take advice, make decisions and implement them quickly. Trustee boards often have an investment sub-committee (ISC) these decisions can be delegated to, but it’s so important in this turbulent time that members of the ISC are in close communication and ready for action.
This is an area where having a professional trustee on the board can really add value. They’re on hand to support quick decision-making and, importantly, sign investment instructions. Professional trustees can also provide reassurance to other board members, drawing on what they‘re seeing across other pension schemes. After all, the impact of the current gilt yield trajectory is having a systemic impact across the DB pensions industry.
Taking it a step further, many sponsoring employers are moving pension scheme governance to a sole trustee. Don’t be misled by the name though – these are appointments of a professional trustee firm and require at least two trustees to manage and peer review governance and decision making. In this scenario, the trustees are empowered to make decisions quickly, whilst being able to draw on the knowledge and experience of the expert team around them.
What happens when the dust settles?
The worst case scenario will be where pension trustees are unable to maintain collateral pools, resulting in liability hedges being unwound (or worse defaulting), just as gilt yields reach their peak leaving the scheme’s funding level exposed to the falling yields.
Whilst it seems economic stability is while off yet, those with strong governance are likely to fare better. Those who fare better could be in a strong position to buy in or buy out their liabilities – after all, volatility often presents opportunity.
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