Recent turmoil in the UK Gilt market resulting from rapid increases in long-term interest rates has grabbed headlines. The UK market’s reaction to changes in the UK government tax and spending policies sparked a rapid bond market sell-off starting the week of September 19, pushing 30-year bond yields from about 3.5% to approximately 4% over just a few days. But the following week yields rose even further, climbing another 1% in only two days from 4% to 5%, and currently remain over 4.5% as of mid-October. These sudden changes had a material effect on many pooled liability-driven instrument (LDI) strategies that are utilized by pension plans as the products scrambled to stay within leverage guidelines. This means that many pension plans had to try to meet collateral calls in a very short timeframe.
Paradoxically, the increase in bond yields was good for most UK pension plans (the value of their liabilities went down more than their assets): their overall solvency increased. But because of the collateral calls, some pension plans found themselves in a liquidity squeeze.
The unprecedented speed with which yields increased was due at least in part to the need for some UK pension plans to sell bonds to meet collateral calls on their interest rate hedges, and for others who were forced to close out some of their derivative positions. Both bond sales and the closing out of derivatives increase bond yields, which requires pension plans to post more collateral, becoming a self-reinforcing spiral. The situation was reportedly dire enough for the Bank of England to become concerned about a systemic breakdown, leading it to announce that it would buy long-term Gilts on September 28th (reducing 30-year bond yields by about 1% almost instantly) and to subsequently increase and broaden these purchases in a bid to calm markets.
It is useful for US plan sponsors and fiduciaries to understand what happened in the UK and how that may or may not be relevant for pension plans in the US. It is commonplace for corporate pension plans in both the UK and the US to employ LDI strategies. Pension plans hold long-term bonds (and/or utilize interest rate swaps that provide similar economic exposure as long-term bonds) which match the long-term cash flows that the pension plans expect to pay in the future. LDI helps to reduce the volatility of a pension plan’s funding level by creating a better match between assets and the present value of liabilities. The liquidity squeeze that many UK pension plans are experiencing is not one that is likely to happen to US pension plans, for a number of reasons such as fundamental differences in the nature of US and UK pension liabilities and in the way that many UK plans choose to implement derivative-based LDI.
While both US and UK plans employ LDI, the way in which this strategy is implemented is often quite different due to significant differences in the structure of pension liabilities. In the UK, corporate pension liabilities typically have a link with inflation– members’ benefit payments are increased with inflation, usually with a cap – while US corporate pension benefit payments are typically fixed. The inflation linkage in the UK means that much more of the value of benefits is pushed further into the future than in the US, which results in a much higher sensitivity to changes in interest rates. A typical UK pension plan will have a duration (a measure of sensitivity to changes in interest rates) of 20-25 years, while a US plan typically has a duration of 10-15 years. For a 1% change in interest rates, the present value of UK pension liabilities will increase or decrease by about 20-25%, versus 10-15% for a US plan. In addition, the present value of UK plan liabilities will be affected by changes in long-term expectations of inflation. If inflation expectations go up, the present value of UK pension liabilities increases as well.
It is possible to hedge changes in both long-term interest rates and long-term inflation using both physical assets (i.e., bonds), as well as “synthetic” assets using derivative contracts, such as swaps. The primary issuer of inflation-linked bonds in the UK is the government, and the expected return of these bonds is equivalent to normal UK government bonds. If a UK pension plan wishes to hedge its inflation exposure without using derivatives, then it needs to hold a significant portion of its assets in UK government-issued inflation-linked bonds, which provide very low expected returns. A more efficient way of managing this risk is to utilize derivatives linked to the change in long-term inflation expectations. These derivatives are known as inflation swaps.
This approach allows the pension plan to hold assets that it expects to outperform its liabilities over time while still managing the risk that inflation increases more than expected. The same logic holds for the use of interest rate derivatives. The UK long-term bond market is dominated by UK government issuance and pension plans find it more efficient to utilize interest rate swaps to help offset the change in value of their liabilities versus tying up too many assets in government bonds. In the UK, it is very common to utilize funds that hold interest rate and inflation swaps, rather than enter into swap contracts directly with investment banks. This practice may have negatively contributed to widespread liquidity problems. More on that below.
In the US, the lack of inflation-linked liabilities and the much deeper bond market relative to the needs of corporate pension plans (which represent a much smaller slice of the US economy when compared with UK corporate pension plans versus the UK economy) means that there is much less of a need to use interest rate derivatives to manage funding level volatility. Instead, US pension plans tend to use regular bonds, both government and corporate, to create the desired match to their liabilities. While many US corporate plans, particularly very large ones, do utilize interest rate derivatives to create a more efficient, more precise match between assets and liabilities, they generally do so in significantly smaller proportions than their UK counterparts.
But the events of September and October 2022 were not caused simply because UK pension plans use lots of derivatives to match their liabilities. The issue came about in large part because of how these derivatives are implemented and how they are collateralized. There are two ways that LDI-related derivatives are employed in the UK:
- “Segregated” – where pension plans enter into derivatives contracts directly with investment bank counterparties or via an exchange (or clearinghouse) or,
- “Pooled” – where pension plans invest in a fund that holds cash and bonds and enters into swaps.
Segregated derivatives mandates are customized and are managed by a specialized firm that handles trading with the banks and/or exchanges and manages all movements of collateral between the parties. Collateral, which is cash or government bonds, covers the current value of the derivative positions. If the pension plan holds swaps whose value has increased by $1m, then the bank counterparty will have posted cash (or government bonds) of $1m as collateral against this. This protects the pension plan in case the bank goes bankrupt suddenly and will not honor the swap through maturity. The reverse is also true. If the value of a pension plan’s derivatives position decreases because interest rates rise, then the pension plan must either post additional collateral to cover the loss or close out the position and settle the loss entirely. Most pension plans that use derivatives like this also hold a significant amount of government bonds relative to the derivative position, which both help them hedge liabilities as part of their LDI strategy and can be used as collateral for their derivative position along with other liquid assets.
Pooled LDI funds provide pension plans with exposure to interest rates and/or inflation on a leveraged basis. A pension plan that wishes to hedge 100m in liability value could buy a pooled fund for 30m – the pooled fund is using roughly 3 to 1 leverage in this scenario. Each pooled fund will have rules about how much leverage it can have. Using pooled LDI funds is seen as being much simpler for pension plans as it is mechanically the same as investing in any other fund – you invest $1 in return for $1 in fund units – and is simpler than using derivatives directly. However, the simplicity of the mechanics can work against the pension investor, and recent events highlight this risk. It is important to note that collateral for pooled LDI funds is typically held in cash.
Interest rates have been rising in the UK, as elsewhere, for most of 2022 in response to inflation and the market’s belief that central banks will raise interest rates to deal with it. The value of all bonds, and swaps tied to bond yields, had been falling steadily from the record high levels seen at the height of the pandemic in 2020. Pension funds with segregated accounts were posting collateral as a result. Pooled funds that hit leverage limits made calls to their investors to inject more cash so that they could maintain their positions. All of this worked as designed, until late September. But the “plumbing” of the system was not designed to raise and transfer cash in large amounts many days in a row, which is what started to happen. A 0.50% increase in long-term bond yields can result in a 10% loss in the value of the derivative in a single day. This loss needs to be covered by fresh collateral within a handful of days (there is always a lag in the notification of a loss, the call for collateral, and the settlement of the collateral call). If it is followed up by a significant loss the next day, and the day after, then things can start to break.
This becomes more problematic in extreme events for pooled funds vs. segregated accounts because the mechanics are different. A segregated account may run low on Gilts to post as collateral and need to source more. The pension plan can then either transfer more Gilts to the collateral account, sell other assets to buy Gilts, or just hold cash. While not desirable, especially if many pension plans are selling assets at the same time, this process should not push Gilt yields higher in and of itself.
On the other hand, pension plans holding pooled funds (or pension plans that traded derivatives directly via exchanges or the clearinghouse) needed to deliver cash (rather than Gilts) to the funds, which needed to post additional collateral to maintain their position. Some of these pension plans will have sold Gilts, or other bonds, to raise cash. This selling process, when many pension plans are doing the same thing at the same time, may have exacerbated the increase in yields, leading to the need to raise more cash. The ability to post Gilts, or even other assets, as collateral can mitigate the liquidity problems, at least somewhat.
Interest rates in the US have risen significantly similar to those in the UK, and pension plans hold long-term bonds as part of LDI programs and consequently have taken losses on these positions. But losses on regular bonds do not require any changes to asset allocations as there is no need for collateral and no leverage. Some US plans will have also lost on their US interest rate derivative positions, but as these positions are far smaller as a proportion of the US Treasury market than UK derivative positions are relative to the UK Gilt market, there is much less likelihood of a systemic effect. While LDI pooled funds exist in the US, they are a niche market relative to the hundreds of billions of derivative exposure held in UK pooled funds.
What has happened in the UK pension arena, while unlikely to replicate in the US, should prompt US pension plan sponsors that utilize derivatives to stress test the portfolio for significant events, especially the impact on liquidity. UK pension plans use derivatives for very prudent reasons (reducing their funding level volatility) and their overall strategies are generally working as planned. However, many pension plans did not anticipate the pressure they might come under to raise cash quickly. Understanding these “second-order” risks is critical to proper pension plan management.