UK Mini-Budget Crisis: The Impact on Plan Sponsors

A series of recent developments in the UK has thrown its financial markets into crisis, causing interest rates to rise at unprecedented speed and forcing many pension schemes to liquidate assets in order to meet increased collateral calls.

UK inflation is at an all-time high, and the Bank of England has been on a tightening trajectory to combat the record inflation. In a contradiction to the BoE’s measures to put the country back on a growth path, the newly-formed government announced a mini-budget on September 23rd, which included a series of deficit-financed tax cuts and an energy price support package. The unfunded cuts amidst already high inflation drew condemnation from experts globally, including the IMF, which issued a statement criticizing the budget and advising its reconsideration.

Markets, across the board, had a knee-jerk reaction to the new deficit borrowing. The pound dropped precipitously against other major currencies and Gilt yields went abruptly higher. This created severe dysfunction in one segment of the fixed income market, which ultimately forced the BoE to intervene to stabilize liquidity through long-dated bond purchases. Volatility in the fixed income market has sustained with nominal and real yields on 20-year Gilts reaching highs of 4.95% and 1.69%, respectively. Stress has spread to other areas of the market, forcing the BoE to expand its purchases to widen the scope of quantitative easing with the hope to stabilize the market.

The Impact on UK Plan Sponsors

Liability-driven investing (LDI) is utilized by a majority of defined benefit plans to manage the risk of scheme liabilities due to inflation and interest rates by aligning the plan’s strategic asset allocation with current and projected future liabilities. In addition to long duration physical assets (Gilts and Corporates), many UK plan sponsors employ a liability hedging overlay using derivatives and repo funded Gilts to gain additional, levered, duration exposure in order to protect their plans against interest rates and inflation moves. These derivatives require cash collateral and margins to be maintained. When rates rise, the present value of overlay position falls and leverage increases, which requires increased collateral to support the overlay. When additional cash is not available for collateral, other assets must be liquidated to fund the margin and collateral requirements.

The UK mini-budget jolted interest rates to rise at unprecedented speed. Margins were squeezed and collateral requirements rose. Defined benefit plan sponsors were forced to sell assets, corporate bonds and Gilts, but also growth oriented assets, notably equities, in a scramble to raise cash to meet the margin calls. This disorderly sell-off in bond markets was temporarily stabilized by the BoE through interventions at the long end of the yield curve.

Key Considerations for US Plan Sponsors

While the market behavior has been broad based and impactful, it is important to keep in mind that not all LDI solutions are designed equally, particularly as it relates to the amount of leverage employed, how often the scheme has rebalanced throughout the rate rise, and liquidity available in other, non LDI assets. Also important is the utilization of a fiduciary investment manager and their level of expertise engaged by Trustees to assist with daily trading and collateral replenishment.

Though the extreme regime shift we have experienced in terms of inflation, central bank policy, and interest rates has been highly correlated among global developed economies, it is important to understand the local impact as to how situations have unfolded in the UK LDI market and how that may compare and contrast to the situation for US Plan sponsors. LDI solutions and their core objectives are just as prominent in the US as they are in the UK. However, the approach and strategies utilized differ on several levels. The UK pension liability measurements are based off UK Gilt and inflation-linked curves, and a result, the “minimum risk” portfolio for LDI and de-risking centers on the same instruments. Conversely, US corporate plans utilize a high quality corporate bond discount rate curve for the various liability measurements and valuations required. Therefore, the “minimum risk” de-risking allocation often centers on a portfolio of longer duration, high quality corporate bonds, complemented with US Treasuries for duration and yield curve and liquidity exposure.

The US LDI market has the advantage of a large and liquid US Treasury Strips market which allows plan sponsors to achieve far longer duration on US Treasuries, in physical space (e.g., 27-28yrs on Treasury Strips Index vs. 15yrs on Long Treasury Index) without employing leverage. The ability to achieve almost 2x the duration with Treasury Strips than found in Long Treasuries reduces the need for US plan sponsors to employ leverage, if at all, to achieve their target hedge ratio and liability management objectives.

The extreme rate scenario experienced in the UK and volatility of government bond yields does not imply that a similar situation cannot happen in the US. US rates have risen, yields are volatile, but the systemic risk and liquidity crisis in the UK seems less probable in the US given various factors both in the bond market, supply of duration, and tools utilized in the US vs. UK LDI markets. It is important to understand the difference among solutions employed, leverage utilized, liquidity source across non LDI assets before one assumes the LDI market is broken or ineffective.

As a leading fiduciary and investment manager to both UK and US pensions, all of whom utilize LDI solutions to various degrees based on their scheme specific situation and risk tolerance, we believe there are a number of key considerations one must make with respect to derivative overlay and levered interest rate hedging strategies. The following list of questions should be part of an overall assessment of an existing or prospective program.

• Is the current collateral sufficient to support current and target hedge ratios?
• Is the cash allocation to manage the hedge ratio overlay held constant to plan assets?
• Is the cash consistently sized to the initial margin requirements?
• Have the collateral call impacts been analyzed for a range of interest rate scenarios?
• When was the collateral monitoring and rebalancing process last reviewed?
• Does the plan have adequate liquidity in the growth portfolio to replenish cash collateral?
• Has the total plan been actively rebalancing and reducing leverage as rates rise?
• Is the plan invested in a commingled product with leverage, and if so, what are the provisions for when the client may be knocked out of the fund, losing duration coverage or conversely, locked in or gated in the fund and unable to adjust their exposure?
• Is the plan invested in a custom account that allows for greater flexibility, communication and collaboration between the sponsor, strategic advisors, fiduciary manager and any LDI managers utilized?
• Is a dedicated trading and implementation infrastructure in place to handle intraday collateral requirements and ongoing portfolio rebalancing, liquidity management, and adherence to Investment Policy targets and ranges?

Properly structured, sized, and managed, an LDI strategy that utilized a combination of long duration physical bond exposure along with synthetic, levered duration based solutions can provide significant surplus risk management efficiencies. The lessons learned during the recent Gilt market sell-off have been painful and unsettling. However, it is important to differentiate the desired outcome of an LDI solution (surplus risk and interest rate risk management) from the structure of the solution in terms of the leverage employed, available sources of collateral and liquidity from non-fixed income assets in order to manage through the recent crisis. In addition, having an experienced investment fiduciary manager with dedicated trading team capabilities and oversight can help plan sponsors navigate across the multiple layers of liquidity management required for an effective LDI and total scheme surplus risk management solution.

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