[discount_rates_problem] [db_funding_objectives] [LDI_for_dummies]

Until late September 2022, few people not involved with UK DB pension schemes (and even some of those who are) would have known about “LDI” (“liability driven investments”), let alone the problem it presented. Most people probably think of investments as financial instruments that can be held or sold with no further consideration needed after the initial purchase (property maintenance is a different issue). However, LDI is actually a long-term swap contract, under which regular margin calls in either direction must be met as an intrinsic element of that contract. Normally, the scheme receives a fixed rate and pays a floating short rate. If the latter increases, then the swap can become unprofitable for the scheme.

A swap contract needs a counterparty, which will normally be a large bank, staffed with specialists in the area. Over the last decade, or a little longer, it seems that trustees and sponsors have gained the idea that these arrangements are tantamount to a free money tree, justifying high levels of leverage. Quite how that developed is hard to fathom, especially since the banks are not known for their generosity. The extent to which trustees and sponsors really understood what was involved is also hard to understand. Having spoken with a couple actuaries working in this area, I have been assured that the arrangements will have been fully explained; I’m just not sure about the understanding. Not actually knowing what they did, I imagine that actuaries treated those contracts within funding valuations at market value without being able to draw attention to the inherent risks, which would have been hard to model.

Many if not most of the LDI contracts are linked to long-term index-linked UK Government bonds (“ILGs”). To the extent that the margin call to be financed exceeds liquidity available, then either other assets must be sold or the sponsors tapped for further contributions. In late September 2022, long ILG yields rose sharply with a consequent fall in their value, triggering larger margin calls than ever anticipated for many UK pension schemes. This was exacerbated by the speed at which yields were changing with real-time assets data hard to access.

In their evidence to the Work & Pensions Select Committee on 16 November 2022, the Association of Consulting Actuaries opined that “… LDI has overall been of significant benefit to defined benefit pension schemes (and their sponsors and members) …” and that “…LDI remains fit for purpose …” but that “… they anticipate there will be some changes in standard market practice in the operation of LDI arrangements, such as standard minimum levels of collateral”. Whether or not past gains can really have been as high as the actual recent crystallised losses (see below) does seem doubtful and it would be good to see some research.

The scale of the problem is hard to measure but it is commonly accepted that many billions of pounds were lost because other assets had to be liquidated at low prices, a sub-optimal outcome. Estimates range between 125 b (JP Morgan) and 500 b (Keating & Clacher). It is hard to be sanguine about how the actual loss will ever be assessed and fully disclosed to the public.

Why so many actuaries were ever, and remained, so enthusiastic about LDI is hard to understand, as are the lack of oversight by either the Pensions Regulator or the Institute and Faculty of Actuaries. Deeper insights than above can be gleaned from articles by Con Keating and Iain Clacher and by Patrick Bloomfield (LinkedIn membership required for the latter).