U.K. Pension Industry’s Reliance on LDIs
BY: Chelsea Wong, RBFL Editor
On September 23rd, 2022, Former Prime Minister Liz Truss shook the entirety of the United Kingdom with an announcement of a budget plan. That budget plan was set to abolish the 45% income tax rate of U.K.’s highest earners and deregulate other industries. Before people had time to argue or even ask, “Why?,” the pound dropped in value against the dollar (to near parity). When the prices dropped, the yields on bonds spiked and a slumbering corner of U.K.’s financial world shook awake. Pensions are often an afterthought, especially for younger generations, just starting out their careers. They may contribute to a retirement plan their employer sponsors or put some money aside in a separate account for retirement. This attitude towards retirement is likely due to a worldwide shift from defined benefit plans to defined contribution plans. At its core, the main difference between the two types of schemes is that defined benefit plans require the employer to manage the funds and ensure that their pensioners get their money when they retire. In comparison, the employees themselves decide how to invest their money in defined contribution plans.
The pension industry quickly became the center of attention in late September 2022, though, and its vulnerabilities came to light. What was once thought of as a secure source of income post-retirement was no longer reliable. When the price dropped on bonds, causing a spike in yields, an avalanche tumbled through the pension market. Asset managers who oversaw the holdings of pension funds required more collateral to maintain the complicated and messy web of financial transactions known as liability-driven investments (“LDIs”). By the end of the week, the Bank of England caved and bailed out the funds by buying bonds for the next thirteen days. The market soon returned to its normal state. This entire debacle resolved itself in a little less than a month, culminating in Liz Truss’s resignation on October 20th, 2022. Though the market was back to normal, U.K.’s regulators and lawmakers were demanding answers from pension fund managers about how they got to this vulnerable state.
In essence, the U.K. pension industry found itself in a precarious position because of its increasing reliance on LDIs. If the funds were directly investing in bonds, then the returns would simply move up and down with yield. However, because of the complexity of the LDI strategy, the funds were left scrambling to complete the transactions they have started when the yield spiked. Direct investments, though, did not produce enough yields for the number of pensioners there were. Some critics argue for the abolishment of the LDI in pension funds, while others argue that LDI itself is not the problem, but its use of leverage is. One leading recommendation is increasing transparency regarding the amount of leverage a particular fund is using to prevent a problem on this scale from happening again.
Key Sources:
Eshe Nelson, Stephen Castle & Mark Landler, U.K. Government Goes Full Tilt on Tax Cuts and Free-Market Economics, N.Y. Times, Sept. 23, 2022, at A1.
Joe Rennison, British Borrowers Face Up to a Broken Mortgage Market, N.Y. Times, Sept. 30, 2022 at B1.
John Ralfe, Making the Switch to Bonds, Treasurer 20, 20 (2001).
Hymans Robertson & Nomura, The Age of Peak LDI, 7 (2018).
Harriet Agnew et al., How bond market mayhem set off a pension ‘time bomb’, Fin. Times, Oct. 8, 2022.