U.K. LDI Guidance Ignores Private Assets, Academics Say

Researchers at EDHEC say the United Kingdom was too hasty in issuing guidelines.

Illustration by II

Illustration by II

The U.K. Pensions Regulator may have acted too quickly in issuing guidance to avoid a repeat of last year’s pension system crisis.

That’s the view of academics at the EDHEC Infrastructure & Private Assets Research Institute, who criticized the regulator for focusing solely on liquidity, rather than solvency and a pension’s ability to pay its beneficiaries what they have been promised.

At the end of September, the U.K. government’s plans to lower taxes and cap energy bills led to a sudden spike in volatility in the value of government bonds, or gilts. The country’s pension funds — many of which use derivatives as part of liability-driven investment strategies — were backed into a corner as rising gilt yields left them overly leveraged.

In November, the pensions regulator suggested funds create liquidity buffers to better protect against yield shocks, conduct stress tests, and identify collateral for derivatives. Two months later, the House of Lords Industry and Regulators Committee blamed pensions for being overly reliant on leveraged liability-driven investing and causing the Bank of England to have to intervene in the market.

“The objective was very focused on what caused the crisis,” said Abhishek Gupta, associate director at the institute.


But that obscured important considerations. According to a paper written by Gupta and his colleagues, Noël Amenc and Frédéric Blanc-Brude, the regulators missed that many defined benefit plans are underfunded and need to take on some risk to satisfy their beneficiaries. In their view, the sole focus on liquidity may not fix the problems faced by these funds.

“They have to be more comprehensive and talk about the solvency as a whole, rather than just the liquidity,” Gupta said. “Then that encompasses more considerations.”

Regulators need to focus on a broader set of assets at the pension, whether these assets generate income, the ultimate function of the defined benefit plan, and its funded status.

The three academics also argue that regulators are not addressing the role of private assets in a U.K. pension portfolio.

“Historically the allocation to private assets hasn’t been huge for these pension funds in the UK,” Gupta said. “This could be why they’re less open to private assets.”

The regulator’s guidance only considers gilts and cash as potential collateral in stress tests. However, the researchers believe that a richer analysis could show the role that cash flows from investments such as infrastructure could play in a stressed scenario.

Of course those findings are not surprising given the nature of the EDHEC Infrastructure & Private Assets Research Institute’s work. Gupta and his team are eager to show the value of adding infrastructure to an LDI-style portfolio. But they note that some private assets can act as a hedge against interest rate risk — primarily real estate and infrastructure.

They add that these assets could reduce the dependency on derivatives for hedging and improve the performance of a pension in stress tests.

“Private assets have the potential to significantly improve and de-risk LDI strategies and, de facto, the need for immediate liquidity related to the margin calls that are implied by the use of derivatives,” according to the researchers.