U.K. officials scrutinizing the need for the Bank of England to buy gilts and soothe the market last year sent a letter to Parliament members on Monday arguing that the use of leveraged liability-driven investing by pensions was to blame. They’re also seeking to improve regulation and reduce the risk of a similar market disruption in the future.
At the end of September, the U.K. government announced plans to lower taxes and cap energy bills, leading to a sudden spike in volatility in the value of government bonds, known as gilts. The country’s pension funds — many of which use derivatives as part of liability-driven investment, or LDI, strategies — were then caught on their heels. To cover their capital calls, the pensions were forced to sell gilts, exacerbating the volatility.
The House of Lords Industry and Regulators Committee sent its letter of concerns to Parliament members Andrew Griffith, the Economic Secretary to the Treasury, and Laura Trott, the Minister for Pensions, after meeting with representatives from the financial services industry and regulators, including Legal and General, the Financial Conduct Authority, and the Pensions Regulator.
“The evidence we heard overwhelmingly suggests that the use of LDI strategies caused the Bank of England intervention,” Lord Hollick, the chair of the industry and regulators committee, said in a statement. “If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction, rather than a downward spiral in government debt markets that threatened the UK’s financial stability and led to significant losses as pension fund assets had to be sold in order to meet LDI liquidity requirements.”
Leveraged LDI strategies were an investment portfolio solution to an “artificial problem created by accounting standards, which drive sponsoring companies to focus heavily on current, rather than long-term, estimates of pension deficits,” according to the committee.
The group also questioned why pension schemes were permitted to borrow and use derivatives in the first place and said it was likely that some pension scheme trustees were not aware of the potential implications of their LDI strategies. “Their decision-making struggled to match the pace of markets,” leading them to become too reliant on investment consultants, the committee said about trustees.
Financial regulators also appeared to have been slow to recognize the systemic risks caused by the investment by pension schemes in more complex strategies and instruments, the committee said. It recommended that the government and the UK Endorsement Board review the current accounting system for pension scheme finances in company accounts, to determine whether derivatives and other instruments should be more tightly controlled and supervised.
“If schemes are to continue to use leveraged LDI, there should be far stricter limits and reporting on the amount of leverage allowed in LDI funds,” the committee said.
It also recommended that investment consultants should be “brought within the regulatory perimeter as a matter of urgency” and be liable for their advice, and said that the government should consider giving the Prudential Regulation Authority a role in overseeing pension schemes.
“This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again,” Hollick said.
The likelihood of LDI strategies causing a similar crisis in the U.S. is low, according to Colyar Pridgen, lead pensions solutions strategist at Capital Group. Other things being equal, similar rate movements in the U.S. might trigger collateral calls at institutional investors, but pension funds here are a more fragmented group with smaller derivative positions, and are trading in markets that generally have greater liquidity, he said.
Still, Pridgen sees value in knowing how leveraged some investors are.
“Improvements regarding transparency and reporting on derivatives positions would frankly be helpful in both the U.K. and the U.S.,” he said.
