Asset managers sharply reduced the amount of debt supporting pension plan investment strategies after the market turmoil triggered by the UK government’s ‘mini’ budget.
Pension plan investment advisers say the levels of leverage offered by some of the largest so-called passive investment (LDI) managers have almost halved in a week.
These measures add to the pressure on pension schemes to raise additional funds by selling assets or bringing in corporate sponsors for a bailout.
“We are certainly seeing an immediate response with managers at all levels reducing leverage,” said Simeon Willis, chief investment officer at XPS Pensions. “I think it’s pretty inevitable that we’ll see a more cautious approach to leverage, after last week’s liquidity crunch.”
Rising UK government bond yields this year have forced pension schemes to add collateral to support LDI strategies that include derivatives. The sharp swings in gilt yields last week following Chancellor Kwasi Kwarteng’s tax cut announcements sparked a crisis as pension schemes scrambled to raise funds.
Although intervention by the Bank of England has since stabilized the gilt market, pension schemes have continued to face collateral calls, accentuated by the new, more conservative stance of banks and asset managers.
Calum Mackenzie of Aon, the pension consultants, said: ‘This is dramatic for pension funds that were using leverage. The amount of leverage a system takes depends on the amount of collateral it has. If you have more collateral, you are not using the same leverage. Higher leverage would generally have been taken by pension funds that had higher return targets.
The LDI contracts are designed to protect approximately £1.5 billion of future defined benefit pension liabilities against adverse movements in interest rates and inflation.
The use of derivatives meant that pension schemes could buy exposure of up to £7 in gilts for every pound invested in the most leveraged LDI strategies, although most used less leverage.
“The average pre-crisis leverage ratio in the gilt market was around two to four times in pooled LDI funds and segregated accounts. This is heading towards the multiple of 1.5 to three times in the new world,” said a pensions consultant who requested anonymity.
BlackRock has issued 70 additional liquidity requests this year to clients under its £10 billion LDI program. Legal & General Investment Management (LGIM), Insight Investment, Schroders and Columbia Threadneedle have also issued similar requests.
“We have reduced leverage in a small number of LDI mutual funds, acting cautiously to preserve our clients’ capital in extraordinary market conditions,” BlackRock said.
All asset managers who manage pooled LDI funds on behalf of multiple clients now want to build stronger safety cushions into these strategies. So even more cash will now be needed as collateral if pension plans are to ensure that coverage ratios – the amount of their assets that are protected – are restored to their target levels.
Dan Mikulskis, partner at retirement advisory firm LCP, said: “The key question now is what is the ‘right’ level of leverage to use in LDI funds. That’s what managers are deciding and communicating right now.
Managers may reduce the amount of hedging exposure provided by each unit of an LDI fund.
“But pension plans will be able to purchase more units with additional assets to ensure their coverage ratios can be restored,” Mikulskis said.
A key indicator used to measure the margin of safety in an LDI strategy is the “basis point until exhaustion”, which describes the expected increase in long-term interest rates before more collateral is required. .
“LDI managers who were happy to manage a haircut of, say, 150bp or 200bp decided to increase those haircuts and require their clients to have a higher proportion of assets held with them as only eligible warranty. This will allow the LDI manager to weather a larger interest rate shock,” said Cardano, a retirement investment advisory firm.
BlackRock has asked its pension plan clients to review their LDI strategies ahead of the closure of the BoE’s emergency purchase facility on October 14.
