UK companies face bigger cash calls from pension funds after LDI crunch

Hundreds of UK companies could face demands for larger cash injections from their retirement schemes after cracks formed in pension funds’ hedging strategies during last month’s crisis in the country’s debt markets.

A rapid drop in UK government debt prices after chancellor Kwasi Kwarteng’s announcement of unfunded tax cuts quickly threatened to spiral out of control when certain pension schemes sold gilts to satisfy their so-called liability-driven investing (LDI) strategies.

These programmes have helped pension schemes to manage risks to retirees stemming from shifts in inflation and interest rates for two decades.

The Bank of England stepped up its support for pension schemes on Monday by expanding the range of collateral that could be pledged at its new short-term funding facility.

But providers say they will still be faced with demands for larger collateral buffers as insurance from pension schemes, meaning schemes may have to lean more heavily on employers.

“Some schemes face hard decisions,” said Steve Hodder, partner with actuarial consultants Lane Clark & Peacock, as LDI strategies had become “less effective”.

“Reducing or ending their hedging could lead to more volatility . . . or a lowering of expected investment returns. Alternatively, reducing growth assets to fund higher hedging buffers would lead to a lowering of expected investment returns. That’s where you might ask employers for more ongoing cash contributions,” he said.

LDI was at the centre of a financial crisis two weeks ago when a sharp and unprecedented rise in gilt yields led to emergency cash calls on thousands of pension schemes holding the contracts.

The Bank of England stepped in to stabilise the market with a £65bn bond-buying programme when schemes struggled to meet the cash calls in time and deepened the drop in bond prices.

In response, the biggest LDI managers in the market have already cut risk levels, particularly in pooled funds, and have asked schemes to hold up to twice as much collateral to maintain their original hedges, say investment consultants.

“We are seeing a new normal emerging of systematically lower levels of LDI leverage,” said Hodder at LCP. “LDI has helped smooth the cost of pension schemes for many employers, and has kept them afloat during the challenging period [of low bond yields]. Effectively, that is a choice now they will not be able to use as efficiently.”

In the long term, the drop in bond prices in the UK and elsewhere helps pension schemes, as it offers up higher returns from assets with tiny risks of default, often with long-term maturities in line with their obligations to retirees.

But in the short term, schemes face the choice of selling higher returning assets to keep their hedges in place, or jettisoning or reducing the protection of the hedging strategy. The latter would leave pensioners exposed to future swings in rates and inflation.

Simon Daniel, a partner in the pensions team at legal firm Eversheds Sutherland, said: “Without LDI in place to do its previous job, there could be implications for employers from a cash and accounting perspective if schemes lean on them more heavily for support.”

An improved overall funding position might insulate many employers from cutting back on the hedging protection, but a quarter of schemes that were doing LDI prior to the turmoil might face a harder cash challenge now, said Hodder.

This week, Nikesh Patel, head of client solutions at Van Lanschot Kempen, a Dutch private bank and LDI investor, estimated that pension schemes would have to come up with as much as £280bn in asset sales to fully recapitalise their interest rate and inflation hedges with new lower levels of leverage.

This is in addition to the £200bn that schemes delivered to meet LDI collateral calls.

Analysts at rating agency Fitch said appetite for LDI solutions by pension schemes would be “greatly reduced” by the crisis, which highlighted the risks of LDI funds that made substantial use of derivatives. “In particular, demand for leveraged LDI structures will have been dealt a severe blow,” they said.

Meanwhile, a ClearGlass analysis of pension schemes with £500bn of assets under management found schemes of £400mn or larger had the biggest exposure to LDI, with about a third of their assets allocated to the strategy. The analysis was conducted in 2020/21, before the crisis.

The Confederation of British Industry, the voice for thousands of employers in the UK, declined to comment.

Additional reporting Chris Flood