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Managing investment and liquidity risk in the current economic climate

Published: 12 October 2022


This statement is for trustees of defined benefit (DB) and defined contribution (DC) schemes and their advisers. It sets out the main points we expect trustees to consider in managing investment and liquidity risks in the face of current market conditions.

In recent weeks, we have seen extreme movements in gilt yields, with unprecedented increases in the days leading up to 28 September. While this means most DB schemes will see an improved funding position, these rises in yields put significant pressure on leveraged liability-driven investment (LDI) funds and resulted in additional capital calls on DB schemes.

These pressures led to the Bank of England (BoE) concluding that there was a material threat of a disruption to financial markets. As a result, the BoE intervened in the gilts market on 28 September to restore core market functioning. This intervention brought down gilt yields by more than 100bps on the day. Further explanation on this can be found in the BoE’s letter of 5 October.

On 10 October, the BoE announced additional measures to support market functioning and an orderly end to its gilt purchase scheme. On 11 October, the BoE announced that it would widen the scope of its daily gilt purchase operations to also include purchases of index-linked gilts.

This statement sets out the actions trustees should consider before the end of the purchase scheme and in the near-term as they navigate continued market volatility.

Liability-driven investment (LDI)

LDI is an investment tool that has existed in the market for nearly 20 years. It has been used to protect schemes from adverse movements in interest rates and inflation, and to reduce the impact on funding levels when interest rates fall. It is usually done either through a segregated mandate for an individual scheme or through a pooled arrangement managed by an LDI fund provider.

The key aim of LDI is that the assets of the pension scheme more closely match the liabilities. LDI is not a return-seeking asset where the expectation at the point of making the investment is that future investment returns will help close the deficit in the pension scheme. Leveraged LDI is a means of increasing the amount of liability matching assets the scheme has in place while maintaining investment in other asset classes. There is no requirement for schemes to use LDI, but many trustees do so as part of their overall investment strategy to balance the risks to their scheme.

This approach of using leveraged LDI has also helped many DB pension schemes to manage the risks to their funding position. Over the past 20 years, as long-term interest rates fell to historically low levels and through market events seen during the COVID-19 pandemic, LDI has meant that the assets in DB schemes increased. During that period, LDI also played a significant role in helping to manage the affordability of DB schemes for employers.

The impact of current market conditions on pension schemes

DB schemes

Many DB pension schemes have experienced improvements in their funding positions during 2022 as a result of the increases in long-term gilt yields. In some cases, these have been significant and have improved security for savers. Aggregate deficits have shrunk as, despite falling asset levels, higher bond yields have generally resulted in significantly lower levels of liabilities. Scheme obligations are now much smaller in absolute terms and, in many cases, schemes may have moved into surplus.

Our previous guidance included messaging for DB trustees and advisers in relation to liquidity plans for LDI strategies. The risk of gilt yields rising was well understood by trustees, advisers and LDI managers. Such risks are pre-planned by keeping aside sufficient proportions of liquid assets, which can then be sold to raise cash that can be posted as collateral.

However, it was the unprecedented speed and magnitude at which gilt yields increased towards the end of September, as well as the ability of schemes and LDI funds to respond to this, that created liquidity pressures as LDI managers urgently sought further collateral. DB pension schemes were not at risk of “collapse” due to the rapid movements in gilt yields, but the key challenge for schemes has been the ability to access liquidity at short notice to maintain their liability hedging positions in an environment when long-term interest rates rose rapidly in just a few days.

A DB scheme that cannot meet demands for more collateral, or was invested in an LDI fund that did not meet its collateral requirements or reduced leverage in order to maintain its position, may lose some of its hedging protection. This would mean its funding level is less well protected against a fall in bond yields in the future.

DC schemes

DC schemes do not use leverage in their default strategies, so the collateral call issue affecting DB schemes with LDI investments is not applicable. However, DC members may have experienced a reduction in the value of their savings, particularly if they are invested in gilts, which have fallen in value as yields have risen over 2022.

The financial impact depends on the member’s allocation to gilts. DC savers tend to have a higher allocation to gilts as they approach their expected retirement date. This means that, depending on the nature of the investments, some members close to retirement are more likely to have seen a greater fall in the value of their DC savings than members who were further away from retirement.

Higher yields will also likely lead to improved annuity rates for savers. Individuals considering purchasing an annuity may find that they can achieve a materially higher pension as yield changes feed through to annuity rates.

While the increase in yields correspond to falls in the current value of gilts, the pension income to be received on these gilts is unchanged for conventional bonds, and increases in line with inflation for index-linked bonds.

Our expectations

DB schemes

We would encourage trustees to engage with their investment advisers to gain an accurate position so they can focus and prioritise the key areas of concern.

We recognise that decisions had to be made at very short notice, with the information available at the time.

The actions trustees might wish to consider will depend on whether they currently hedge against interest movements and, if they do, whether this is through a segregated mandate or a pooled fund.

Feedback we have received from individual schemes and investment consultants suggests that segregated funds have had greater flexibility in the choices they made than some pooled funds.

Schemes that do not currently hedge will potentially have seen significant improvements in funding levels over the last few weeks. These schemes may wish to consider whether they review their asset allocation or their decision to hedge in light of recent movements.

Trustees will need to consider whether the funding position might improve further if yields increase or whether they might face a reduction in their current funding position if yields fall. Trustees should also look at the ability of the covenant to support investment risk, recognising that current market events might also have impacted covenant strength.

Trustees should consider the points below relative to their current position and how significantly they have been impacted by market movements:

Review your operational processes

Recent events have shown how important it is that trustees are able to act quickly when needed. They should have robust procedures in place to help them respond to changing circumstances, make decisions and implement them where the need arises. Consideration should be given to whether adding one or more professional trustees would help in these circumstances.

Ensuring schemes and trustees can implement their liquidity and cash management plans, and that there are contingency plans in place will help ensure they are well prepared for market changes and can adapt quickly. This includes considering the governance processes in place to buy and sell investments, and the decision-making requirements – such as granting LDI managers power of attorney of some scheme assets to enable swifter trading.

Review your liquidity position

We expect trustees to discuss their current liquidity position with their advisers, including understanding their sources of liquidity, reviewing any liquidity waterfalls and topping up or increasing collateral where appropriate.

It is likely that the balance of liquid to illiquid investments will have changed within the scheme. Schemes may have had to realise some liquid investments to meet collateral calls, but some illiquid investments may have been less susceptible to recent market movements. Trustees should review previous cash management and disinvestment plans and revise them if necessary.

Schemes should have a clear understanding of the current value of their investments and the relative liquidity of those investments.

In some cases, schemes might discuss with their employer the potential for them to provide additional collateral where the scheme is unable to create enough liquidity from the scheme assets. Trustees could discuss whether the employer is able and willing to accelerate future contributions or provide liquidity by other means. A loan arrangement may be an option but trustees would first need to carefully consider the associated risks and take legal and financial advice. Trustees may only borrow on a temporary basis and for the purpose of providing liquidity to the scheme, and may also be subject to scheme-specific restrictions. Employers may consider that maintaining a hedged position against interest rate and inflation risks is also in their interests, to reduce the likelihood of having to make higher deficit repair contributions in the future if liabilities increase.

If maintaining a hedged position is considered appropriate by trustees, they should consider whether they have sufficient liquidity to meet collateral calls in a more volatile environment. If collateral calls would require trustees to dispose of less liquid assets with a significant haircut, trustees should consider obtaining advice on whether it would be appropriate to do so or whether to maintain a reduced level of hedging.

Review your liability hedging position

As part of reviewing their risk profile, trustees should consider the extent of their liability hedging position. This will already be a key consideration for schemes that have experienced liquidity difficulties but is an issue all schemes face in the current environment, particularly those that did not have a significant level of matching assets relative to liabilities.

We expect that some LDI funds are likely to move to a lower level of leverage to better manage their collateral requirements, which will reduce the hedge ratio for investors in those funds. Trustees with investments in these funds should consider their position with their investment advisers in light of this. There may be more market opportunities for some schemes to increase or replace hedging or lock in some funding improvements, including access to the insurance market. Although there are likely to be capacity constraints in some parts of the bulk annuity market, trustees wishing to explore these opportunities should focus on putting themselves in as good a position as possible for when capacity allows them to move forward.

Where trustees are entering into LDI, we expect them to consider the level of leverage and the implications of collateral calls, particularly at this time of higher volatility.

Review your funding and risk position

While some schemes have experienced challenges in delivering collateral on accelerated timescales during recent events, and liquidity will be the main focus for many trustees, it is useful for all schemes to review their current funding positions in light of market changes. Many schemes are likely to see an improvement in funding and may be approaching funding triggers put in place for action. It will also likely have had an impact on longer-term funding objectives as schemes may find themselves ahead of their target or expected position.

The balance of risk in the scheme’s portfolio may have changed and should be reviewed in light of market conditions, and trustees may consider a rebalancing of their risk profile.

Consider how current yields impact other areas of the scheme

Higher yields impact on transfer values. Trustees should monitor the appropriateness of the assumptions used in calculating transfer values and review the transfer value basis in light of this. Market volatility often presents opportunities for scams, and trustees should remain vigilant and follow best practice in this area.

DC schemes

Pensions are long-term saving vehicles, and it is important that savers do not make hasty decisions based on short-term volatility. It’s also important for savers to be aware of the risks from pension and investment scams, especially in times of heightened uncertainty.

As well as rising interest rates, DC savers are also subject to the impact of high inflation, particularly where they have high allocations to cash, for example as part of a lifestyle strategy as they approach retirement.

Trustees should:

  • maintain a long-term perspective when reviewing recent market volatility and performance
  • review their investment strategy, and operational factors in executing this strategy
  • communicate with savers who are approaching retirement to make them aware of their options and emphasise the importance of seeking financial advice
  • encourage savers to seek regulated financial advice or speak to MoneyHelper before making decisions about their pension savings in light of market conditions
  • remain vigilant for scams and suspicious transfers
  • review processes to ensure they can act at speed where necessary

Next steps

We are monitoring the situation in the financial markets closely to assess the impact on pension schemes. We are speaking to trustees and their advisers about how schemes are responding to current market volatility, as well as industry representative bodies.

These events have highlighted the liquidity and operational issues in responding to yields rising at a much higher pace that anticipated. As the BoE recently stated, insuring schemes against all extreme market outcomes might not be a reasonable expectation but it is important that lessons are learned from these recent events.

We will continue to monitor the situation closely this week, and following 14 October, working closely with our regulatory partners in the BoE, the Financial Conduct Authority and the government. We will provide further updates to trustees if needed and as the situation develops.