As the Bank of England ends its intervention in the gilts market, the asset management industry is conducting a post-mortem on the U.K. pension system crisis — and asking whether something similar could happen stateside.
At the end of September, the U.K. government announced plans to lower taxes and cap energy bills, leading to a sudden spike in volatility in the value of government bonds, known as gilts. The country’s pension funds — many of which use derivatives as part of liability-driven investment strategies — were caught on their heels as rising gilt yields left them overly leveraged.
The Black Swan event has left U.S. pension plans worried about their liquidity and leverage. According to industry experts, while that concern is warranted, the U.K. and U.S. markets are fundamentally different, which means U.S. plans may face fewer — or at least different — risks.
“Pension funds in the United Kingdom were historically underfunded,” said Richard Bruyere, managing partner at consulting firm Indefi. “In order to bridge the funding gap, they had to introduce a significant degree of leverage to invest significant amounts in growth assets.”
By adding synthetic exposure to U.K. gilts and sterling bonds, these pension funds freed up cash to invest in illiquid strategies like private equity and real estate. This improved their funded status significantly: Most were at least fully funded, if not 120 or 130 percent.
“They accepted derivatives for the past decade or more as a very efficient and up-to-this-point effective tool to mitigate interest rate risk,” said Gary Veerman, head of LDI Solutions at Capital Group.
But the market for these derivatives is relatively narrow. According to Bruyere, foreign institutional investors have “very little incentive” to invest in U.K.-denominated bonds. This, coupled with the fact that just a few asset managers in the United Kingdom dominate the LDI market, led to concentration in the strategy.
Pension plans in the United States are not subject to the same exposure and risks for a variety of reasons. First, not all pension plans employ the same investment strategies. For those that do employ LDI stateside, the implementation is different than it is in the United Kingdom, according to Veerman.
He noted that the “core part” of hedging programs in U.S. LDI strategies is typically corporate bonds. “You almost take derivatives off the table,” he said. “Given the depth and breadth of the US treasury market, STRIPS and treasuries balance out credit risk.”
When these plans do use derivatives, they use them to “tighten the screws on the hedge,” he added. “The derivatives in the United Kingdom are the screw.”
Some U.S.-based pensions do use derivatives as a central part of their strategy, particularly those that employ portable alpha programs. Others use risk parity strategies, subscription lines of credit in the private markets, and levered strategic asset allocations, all of which add short-term duration risk — the same risk that U.K. pensions were exposed to.
But these U.S. pension funds do not pose the same structural threat to the financial system, given that they do not make up a majority of the investors in the market.
Still, according to Bruyere and Veerman, U.S. investors can learn lessons from the LDI blow-up. After all: “It’s not an issue of LDI,” Bruyere said. “The issue is leverage.”
Veerman noted that plans should consider whether their portfolio illiquidity is too high. “There’s nothing wrong with illiquid investments, but when you add them up, they become a big headwind,” he said.
Bruyere, meanwhile, is encouraging investors to make sure they understand the risks of their investments.
“Stress test your scenarios,” he said. “And don’t just disregard them. Assign to these stress tests a probability that is maybe higher than you may have 10 or 20 years ago.”