How UK pension plan coverage became a trillion pound gamble


LONDON, Oct 15 (Reuters) – It all started quite simply: British pension schemes were looking for a way to match their assets with future pension payments.

The programs set up for the Boots pharmacy and the bookseller WHSmith were the first to adopt in the 2000s an investment strategy consisting of exchanging stocks for bonds, to protect themselves from variations in interest rates.

But fifteen years on, the strategy now adopted by nearly two-thirds of pension schemes has come to revolve around financial derivatives rather than just bonds – injecting an increasing amount of risk into schemes that is only now becoming apparent. with rising interest rates.

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In the so-called LDI or liability-driven investing strategy that has become popular, pension plans would use derivatives – contracts that derive their value from one or more assets – to hedge against potential rate fluctuations. of interest. With a small amount of capital, they could get significant exposures.

There is a catch: if the derivative becomes onerous for the pension fund due to a change in the prices of the underlying assets, for example, it can be called for more money, sometimes in the short term.

For a long time none of this mattered and consultants predicted in 2018 that the market would soon reach “the age of peak ILD” – it was so popular that the pensions industry lacked assets to be hedged.

LDI’s assets have quadrupled in a decade to 1.6 trillion pounds ($1.79 trillion) last year.

But the strategy has gradually become more risky, according to interviews with pension plan administrators, consultants, industry experts and asset managers. Things started to sour when Britain’s ‘mini budget’ on September 23 triggered a rise in UK government bond yields, prompting pension funds to rush to raise funds to back their LDI hedges.

These derivatives almost imploded, forcing the Bank of England to commit on September 28 to buying bonds to calm the panic.

The scale of the money using the LDI strategy and ever higher borrowing via derivatives had magnified the risks that seemed hidden during a decade of low interest rates.

When rates started to rise in 2022 and risk warnings intensified, plans were slow to act, people said.

“I don’t like the term (LDI) and never have, it’s been hijacked by consultants and turned into what we see now,” said John Ralfe, who in 2001 headed the move from the £2.3 billion Boots Pension Fund to bonds. The fund has not taken on debt, he told Reuters.

“Pension schemes were borrowing in disguise, it’s absolutely toxic,” Ralfe said. “There was a lot more risk in the financial system than anyone – including me – would have thought.”

Boots did not respond to request for comment on Friday. WHSmith did not respond to request for comment Thursday.

Globally, investors are concerned about other financial products based on low interest rates now that rates are rising.

“The so-called LTD crisis in the UK is just a symptom of greater economic malaise,” said Nicolas J. Firzli, executive director of the World Pensions Council.


In the two decades since Ralfe joined Boots, defined benefit pension schemes – which guarantee retirees a fixed amount of pension payments – have taken on LDI and derivatives, using them to borrow and invest. in other assets.

If the leverage in the LDI strategy was three times, for example, that meant the scheme only needed to spend £3.3m for £10m of interest rate protection.

Instead of buying bonds to protect against falling rates – a key determinant of a plan’s funded position – a plan could cover 75% of its assets, but only tie up 25% of the money, using the rest for other investments.

The remaining money could be funneled into higher yielding stocks, private credit or infrastructure.

The strategy worked and the plans’ funding gaps narrowed because the hedges made them less exposed to falling interest rates. Lower interest rates force pension plans to hold more money now for future pension payments.

This appealed to businesses and regulators.

Asset managers including Legal & General Investment Management, Insight Investment and BlackRock offered LDI funds in a low-margin but high-volume business. The FCA, which regulates LDI providers, declined to comment.

Consultants such as Aon and Mercer have introduced LDI to trustees, while The Pensions Regulator (TPR) – the government entity regulating pension funds – has encouraged schemes to use liability matching to reduce deficits.

Almost two-thirds of UK defined benefit pension schemes use LDI funds, according to TPR.

The strategy worked as long as government bond yields remained below pre-agreed limits embedded in the derivatives.

“LDI had been viewed (by clients) as a fire and forget strategy,” said Nigel Sillis, portfolio manager at Cardano, which offers LDI strategies.

The industry has been “a little complacent” about the knowledge of pension plan administrators, he added.

The risk increased over time. A senior executive at an asset manager that sells LDI products said leverage had increased, with some managers offering bespoke products of five times the leverage, up from a high of two or three times ten years ago.

Pension plans had rarely been asked for additional guarantees before 2022, and a risk-averse industry had become less cautious, the executive said, speaking on condition of anonymity.

TPR says no scheme ran the risk of becoming insolvent – ​​rising yields actually improve the funding position of the funds – but the schemes did not have access to cash.

However, the regulator acknowledged this week that some funds would have suffered.

When yields jumped in an unprecedented move between September 23 and 28, pension plans scrambled to find cash as collateral. If they didn’t find it in time, LDI providers cut their hedges, leaving plans exposed when yields fell following BoE intervention.

According to Nikesh Patel, head of client solutions at asset manager Kempen Capital Management, a small minority of plans have seen their funded position deteriorate by 10-20%.

Simon Daniel, a partner at law firm Eversheds Sutherland, said pension schemes are now arranging relief facilities with their sponsoring employers to secure cash as collateral.


The risks associated with ILD had been reported for years.

The Bank of England’s Financial Policy Committee highlighted the need to monitor the risks associated with the use of leverage by LDI funds in 2018, BoE Deputy Governor Jon Cunliffe said. this month.

There have been more warnings this year, especially as rates have started to soar.

Mercer retirement consultants warned clients in June to “act quickly” to ensure they had money. Aon said in July that pension funds should prepare for “urgent intervention” to protect their hedges.

TPR had “systematically alerted trustees to liquidity risk,” CEO Charles Counsell said this week.

Yet in the slowly changing world of pension funds, where trustees and consultants tend to craft changes in investment strategy over years, not weeks, few funds reduced leverage or increased guarantees, according to consultants and trustees.

Some of the more sophisticated pension plans even increased the LDI this year, after rates started to rise.

The Universities Superannuation Scheme, Britain’s largest pension fund, earlier this year partly linked the decision to increase exposure to LDI to the “obvious possibility of further declines in UK real interest rates”. , against which he had to protect his portfolio of 90 billion pounds. .

Yields on UK 30-year inflation-linked bonds have tripled since late June.

In a statement this week, USS defended its approach, noting that it had enough cash to meet margin calls and was not a forced seller of assets. He said he was comfortable if rates rose and coverage became more expensive.

This discussion had barely begun elsewhere.

“When people talked about interest rates, all they obsessed over was falling interest rates,” said David Fogarty, independent trustee at Dalriada Trustees, a provider of professional pension plan administrators.

“There hasn’t been a lot of talk about leverage either.”

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(Reporting by Tommy Reggiori Wilkes and Carolyn Cohn) Additional reporting by Sinead Cruise, editing by Deepa Babington

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