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Finance & Banking
October 4, 2024

Pension funds rethink hedging tactics after UK crisis

In response to the recent UK crisis, pension funds are reassessing their hedging strategies to enhance financial resilience. This reevaluation focuses on identifying vulnerabilities and adapting to changing market conditions. As pension funds aim to safeguard assets and ensure stability, they are exploring innovative approaches and lessons learned from past challenges. The shift reflects a broader trend towards more dynamic and responsive risk management in the investment landscape.

Two years after market turmoil threatened the UK’s £2 trillion ($2.7 trillion) pension industry, the hedging strategy that contributed to the crisis is gaining traction—though providers claim it now involves less risk. In September 2022, the then-Prime Minister Liz Truss introduced a ‘mini-budget’ featuring unfunded tax cuts, which unsettled investors and led to a significant sell-off of UK government bonds, known as 'gilts.'

This situation created a disastrous ripple effect for numerous pension funds that were not only heavily invested in these assets but also employed leveraged financial instruments to protect against sudden interest rate changes and inflation, utilizing a strategy termed 'Liability Driven Investment' (LDI).

The sharp fluctuations in gilt prices resulted in collateral calls on pension funds' LDI positions, prompting fund managers to urgently sell the most liquid assets to generate the necessary cash.

For many funds, this meant offloading UK government debt in a rapidly declining market. The Bank of England had to intervene by purchasing gilts to stabilize their prices. Since that time, regulators have been advocating for increased collateral and decreased leverage to prevent a recurrence of the crisis while acknowledging the protective role hedging plays in asset management.

"LDI is as crucial as ever for pension schemes, especially as many are aiming to manage potential surpluses and reach their intended objectives," stated Adam Baker, a manager in BlackRock’s LDI division.

LDI providers indicated that they had implemented several measures to enhance the safety of the strategy, including lowering leverage and reserving more liquid assets, like corporate bonds, as collateral that can be easily liquidated.

However, executives admitted that this new approach is still untested, and no system can withstand every possible shock. Termed 'LDI 2.0,' four leading LDI providers—Legal & General, Insight Investment, Schroders, and Columbia Threadneedle—reported an increase in pension funds' utilization of hedging instruments, including LDI.

Legal & General Investment Management (LGIM) noted that its defined benefit pension scheme clients have raised their hedging ratios to 86-87% of their liabilities, marking an increase of up to seven percentage points over two years, with LDI being the preferred method.

In part due to stricter regulations, LGIM's pooled funds have enhanced the collateral available to manage interest rate fluctuations of 3 percentage points or more, up from the previous 1.5 to 2 points, thus providing a larger buffer during crises.

"Many refer to it as LDI 2.0," said Anne-Marie Morris of LGIM. Insight Investment reported that its clients were increasing their use of hedging, while Schroders indicated that LDI is being utilized more frequently by both existing and new clients, although they did not provide specific data.

According to pensions consultancy XPS, the proportion of LDI assets among its clients has risen by 8 percentage points over the last two years. Meanwhile, pension funds have been able to reduce their leveraged hedging positions, largely due to rising interest rates improving their funding status by lowering liabilities.

Data from The Pensions Regulator (TPR) shared with Reuters revealed that the value of leveraged LDI positions is currently between £600-700 billion, roughly half of what it was in late 2021, indicating a reduced but still significant exposure.

The regulator noted that while it has information on traditional assets, it does not specifically track unleveraged LDI positions, which may include standard gilt funds and corporate bonds that do not require collateral. "Defined benefit pension schemes are better funded than they have been in a long time," remarked Neil Bull, TPR's executive director of market oversight, adding that TPR will continue to oversee potential LDI risks.

For questions or comments write to writers@bostonbrandmedia.com

Source: Reuters

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