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What does UK gilt volatility mean for pensions governance?

What does UK gilt volatility mean for pensions governance?
(FT Money)

The recent volatility we saw in the gilt market came with a lot of noise surrounding it.

Pension schemes, specifically defined benefit, using liability-driven investment strategies faced large, immediate and in some cases multiple collateral calls.

The absorption of this cash caused stark liquidity issues for some and a complete inability to service their LDI hedges in others.

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Over the past year in particular, yields have been steadily increasing, causing their price to drop. This trend was supercharged by the “mini" Budget of the Lizz Truss government. Massive long-term borrowing contained in that Budget had the effect of raising these yields even further.

This caused those leveraged LDI products to start posting large collateral requests from their owners. The irony here is that in many of these cases the capital calls were met by liquidating the very same gilts that had caused the issue in the first place, thus exacerbating the situation.

The sharpest impact was felt where hedges were not actively monitored or maintained.

What does this mean for pension scheme governance?

Strictly from a risk management point of view, these LDI strategies are not risk free and should never have been described in this manner.

Given such an important and consequential aspect of these products was glossed over (or ignored) by many of the parties involved, it became more and more likely that if/when an event, such as the one experienced, occurred, there would be mass confusion.

One area I would expect to see a rigorous review of is in the level of leverage employed by these LDI products, led by The Pensions Regulator and supported by various industry and government entities.

Some may be surprised to find that these same levels of leverage do not exist in their US counterparts.

One anecdotal reason for this dates back to Robert Maxwell and the Mirror Group Pensions scandal. In the aftermath of such a spectacular lack of oversight/governance, many, including TPR, felt it was critical to adopt methods of meeting any future obligations.

LDI became the ubiquitous strategy with the level of leverage ticking up incrementally over time (as these things tend to do once found to be successful).

I would also hope to see pension schemes trying to better understand these products and the inherent risks that come with investing in them.

Rather than taking a speculative view on where rates might go over the course of the next 12-18 months, they should take a worst-case scenario approach. Truly understanding your risk profile would help make the investment decision-making process more robust.

What does this mean for pension liabilities?

In the aftermath of the "mini" Budget, there was a lot of hyperbole as to the impact this would have on pension schemes.