The LDI meltdown and the illusion of an optimised risk budget

Recent events have seen a material degradation of leveraged liability-driven investment (LDI) allocations by defined benefit (DB) pension funds in the UK. Although the media has covered in detail the mechanism of what has been called a meltdown – and its consequences – the causes appear to be less well understood.

We believe that the main driver of the breakdown appears to have been the traditional investment and risk management strategies implemented by DB pension funds. In our view, these strategies are often an assortment of individual ideas rather than an integrated framework that can ensure portfolios can withstand market shocks.

To understand what happened, we will start with a general review of the risk budgeting approach that helps set asset allocations and risk management strategies. We then describe the implications of an optimised risk budget in terms of a DB pension fund’s balance sheet structure. The article concludes with selected recommendations for better pension fund management.

Risk budgeting approach

Most DB pension stakeholders view risk budgeting as an ideal to be reached by splitting risks into: 

• Unrewarded ones that need to be hedged
• Rewarded ones that need to be diversified and allocated optimally. 

In an asset allocation framework, liability-driven risks such as interest rate sensitivity (essentially a duration gap between liabilities and assets) and inflation indexation emanate from the choice of the discount across the yield curve. The discount rate reflects nominal interest rates and inflation expectations, that is, a projected real yield at which the liabilities are supposed to accrue. Assets are expected to grow faster than this discount rate.

Liability risks are understood to be unrewarded and need to be hedged partially or fully. Hedging refers to matching liability risks with assets with similar features – i.e. similar duration and inflation sensitivity – as those of the liabilities. This can be done by, for example, buying UK government bonds (gilts) and index-linked gilts and entering into interest rate and inflation swaps.

It is important to underline that the main risks against which DB pension funds want to hedge are interest rates falling and inflation expectations rising (i.e. discounted liabilities increasing and solvency levels decreasing). The risk of any major increase in interest rates was not truly considered as it was seen as a positive development: Partially hedged liabilities would decrease faster than assets, which would lead to an improvement of the funding level defined as the ratio of assets to liabilities.

One other element needs to be taken into account in this context: the closure of DB schemes, which led to shorter liability duration. As a result, pension funds have less time to return to solvency.

Fund managers also decided to reduce their investments in volatile, return-seeking asset classes such as equities to avoid large drawdowns that would be difficult to recover from in shorter amount of time. Instead, they focused on corporate bonds, which provided positive real yields, and private markets, which benefited from an illiquidity premium.

Optimising the risk budget and the asset allocation

The optimised risk budget defines the asset allocation in terms of: 

• An excess return that has to be generated to beat the discount rate
• A low level of volatility that has to be maintained to avoid sudden drawdowns.  

Stable, but low-yielding asset classes such as gilts had to be leveraged to maintain an excess return (and beat the real discount rate) using interest rate swaps and repos. Since gilts were viewed as ultra-safe (effectively risk-free) assets, this was not viewed as a problem. Cash was shorted and used as collateral for the interest rate swaps. Again, this was not seen as problematic as the SONIA [1] rate was close to 0%. 

As a result, the optimal asset allocation in 2021 looked like this:

The short cash position shows the evolution of leverage along time, alongside the steady increase in bond allocation since 2018 (see Exhibit 1).

The consequences of optimisation

This breakdown between asset classes and levels of risk looks similar to collateral debt obligations (CDOs) with four tranches with different risk and return profiles (see Exhibit 2).

The CDO market collapsed during the 2008 Global Financial Crisis because the value of the underlying assets (mortgage-backed securities) behind the super senior tranche plunged. Today’s parallel with the GFC was the war in Ukraine, which led to higher interest rates and a flatter yield curve as inflation rose and public finances deteriorated. Consequently, five things happened: 

• Leverage worked against pension funds which had to post collateral
• The leveraged LDI/super senior tranche decreased in value
• The cost of cash collateral increased
• The value of other liquid asset classes fell, so they provided less collateral
• Illiquid assets were, unsurprisingly, difficult to liquidate at short notice (especially during periods of market turmoil). 

In summary, the UK market faced a meltdown similar to the CDO market in 2008, albeit on a much smaller scale.  

Our observations

Leveraging LDI allocations does not necessarily create risks, but it is important to examine the collateral: 

• When leveraging an interest rate hedge, pension funds may need more collateral
• If they need more collateral, the rest of the investments in the DB pension fund’s asset portfolio has to be acceptable and liquid enough for collateral posting or margining (for cleared positions)
• Therefore, DB pension funds need to accept either more volatility (if the liquid assets are risky) or less return (if the liquid assets are not) 

Alternatively, DB pension fund managers may decide against leveraging their LDI allocation and invest in lower-yielding safe assets. In either case, the risk budget is not optimised – at least not based on the principles established by current actuarial norms – but from a risk/return/liquidity perspective, the investment strategy is much more consistent.

Looking ahead – solutions

It is unlikely that the current actuarial norms will change in the short term. We can nonetheless focus on effective and immediate solutions: 

• Helping corporate sponsors lend money to their pension funds temporarily and recover any surplus without punitive tax rates. Companies such as Sainsbury’s have already done so. A cash guarantee or a temporary contribution by the sponsor would solve most of the pension fund problems, especially if the aim is to go to buyout in the short to medium term. 
• The recent sharp increase in interest rates has now rendered many pension funds fully funded on an actuarial basis. Corporate sponsors therefore have even fewer incentives to increase their direct contributions as this would only increase the trapped surplus. Unless the sponsor can claim any excess cash (without relying on roundabout ways such as the use of captive insurance companies), they will not be inclined to follow this route.  
• If DB pension funds want to maintain their allocation to LDI, there are at least four ways to treat and manage collateral/ margining. These would require (minor) changes in regulations as well as the use of a different risk management instrument: 
• Collateral transformation/swaps, whereby one counterparty swaps lower-quality collateral with another counterparty who holds higher-quality collateral. This is mostly feasible when the exact terms can be negotiated with each counterparty, e.g., under over-the-counter (OTC) agreements.
• Clearing requirements: After the Global Financial Crisis, counterparty risk was avoided. The preferred solution was clearing on the basis of cash. However, by pushing clearing for LDI pooled funds, the authorities created a significant liquidity risk (through margin calls). In that respect, the current pension fund exemption should be maintained.
• Dirty Collateral Schedule Agreements: CSAs define admissible assets for collateral purposes for OTC derivatives. ‘Clean’ CSAs only accept cash and government bonds. ‘Dirty’ CSAs also accept corporate bonds and structured products such as asset-backed securities as well as less liquid asset classes. Nowadays, the bulk of OTC agreements rely on clean CSAs. Though derivative pricing has become less transparent, we believe it would be preferable to go back to dirty CSAs to some degree. One would still avoid illiquid investments and structured products that are difficult to value. This option is not a panacea, however, as the haircut may turn out to be severe for assets such as highly rated corporate bonds, but it would at least reduce the need to liquidate corporate bond portfolios in a fire sale.
• Buying interest rate swaptions: Options on interest rate swaps can provide protection while retaining upside participation in an increase in interest rates without the liquidity risk. They nonetheless cost money, usually the upfront payment of a premium, and they are more complex to model and include in pool funds. Moreover, the market remains relatively shallow and may not be able to meet the needs of all UK DB schemes.  
• Instead of focusing on hedging interest rate sensitivity, pension funds should aim to match the actual pension cash flows themselves. Such a cash-flow driven strategy is not new, but would mark a fundamental investment strategy change for pension funds. A CDI strategy does not necessarily require LDI allocations, but real assets that deliver both a minimal excess return and some inflation offset.
• The aim of the investment strategy becomes matching each liability cash flow individually, independently of the discounting of the entire liability cash flow profile. Short-term market movements may lead to divergence in the valuation of assets and liabilities (independent of the valuation methodology). Sponsors and DB pension fund trustees would need to accept increased funding level volatility and tracking error versus the liabilities. In practical terms, though, long-term objectives, the structure of the asset portfolio and the level of risk are more closely aligned.
• Corporate sponsors may also need to increase their contributions, invest in more stable long-term assets and further reduce their exposure to volatile, return-seeking ones. The investment universe should include (illiquid) real assets – mostly private credit, which is more stable and has a set of contractual cash flows – but these would not be at risk of being liquidated to meet cash collateral and margin calls.
• In doing so, one can avoid creating a multi-tiered investment strategy with different levels of liquidity and leverage since there would no longer be any need to fully hedge interest rate and inflation sensitivities.    

References

¹ Sterling overnight index average

² “The weighted average proportion of assets held in cash and deposits being negative represents a number of large schemes with significant negative cash holdings which are likely to be related to investments such as swaps and repurchase agreements.” Purple Book, PPF, March 2021

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