“How did you go bankrupt?” Bill asked. “Two ways”, Mike said. “Gradually, then suddenly.”
Ernest Hemingway, ‘The Sun Also Rises’
By all accounts had the Bank of England not intervened in the markets earlier this month quite a few pension scheme trustees might have been having very similar conversations. In Hemingway’s novel his protagonists travel to Pamplona for the bull running, for many Defined Benefit or DB schemes the danger came from the bear markets that followed the Chancellor of the Exchequer’s ‘mini-budget’ on 23 September 2022.
The problems confronting DB schemes arose from a strategy known as “Liability Driven Investment” or LDI. LDI aims to match a scheme’s assets to its liabilities, it is intended to allow trustees to minimise and manage their liability risk and emphasises their scheme’s liabilities over growth. It developed in response to changes in accounting standards, improvements in life expectancy and the increasing regulation of pension schemes. As a strategy it seems simple, even sensible, and arguably it helped DB schemes weather the financial crisis in 2008. It grew in popularity and reports suggest that by 2021 collectively schemes held around £1.6 trillion in LDI assets.
What could go wrong? In order to ensure that their schemes had sufficient liquidity to meet their liabilities and to hedge against the effects of inflation and interest rates, LDI was commonly used in association with derivatives contracts and in addition were often leveraged. When the markets responded negatively to Kwasi Kwarteng’s ‘mini-budget’ it prompted a sell off of UK government bonds. The sudden fall in the value of the gilts they held led to trustees being called on to provide additional collateral to cover their obligations or else sell gilts in a market that had quickly become illiquid. This further depressed prices and merely led to further sales of gilts. With many DB schemes reportedly on the verge of defaulting, and with the risk of contagion spreading to other sectors in the financial markets, the Bank of England then intervened and announced a programme to purchase UK government bonds.
This move helped stabilise the markets and avoided a situation where the affected DB schemes were at risk of becoming technically insolvent. However, the Bank of England’s programme is intended to be limited duration only and what happens once it ends remains to be seen, especially since the markets remain uncertain about key aspects of the ‘mini-budget’.
What lessons have been learned? Like the bulls in Pamplona bear markets are difficult to outrun. Trustees of DB schemes need to take steps to ensure their schemes have sufficient liquidity and may need to re-capitalise. They should review their investment strategies and identify whether any LDI strategy they have adopted includes the use of derivatives and/or leveraging. It may also be time for them to re-visit their trustee knowledge and understanding requirements in order to better understand their investments and the associated risks. It may be too early to confirm that all the problems have been resolved, but as Hemingway’s novel concludes, “Isn’t it pretty to think so?”