Pension experts have told MPs they were “absolutely appalled” at the level of “hidden” borrowing in UK pension schemes, which almost toppled some funds during the bond market crisis in September and forced money managers to sell up to £500bn of assets.
Speaking to politicians on the Work and Pensions Committee on Wednesday, academics and pension experts laid bare the risks certain forms of liability-based investing, or LDI, pose to retirement savings.
Defined benefit pension funds, which guarantee a fixed pension at retirement, regardless of how well or poorly investments have performed, ran into trouble during the bond crisis. As it turned out, they relied heavily on LDI hedges, holding government bonds as collateral. When the value of government bonds plummeted after Liz Truss-Kwazi Kwarteng’s disastrous mini-budget, pension managers were forced to sell their holdings in a hurry to raise money. This drove the value of bonds further down, creating a “doom loop”.
Within days, the Bank of England had to step in with an emergency £65bn bond-buying program to prevent a large number of LDI funds from going bankrupt.
John Ralfe, an independent advisor and pensions expert who formerly managed the Boots pension plan, said he was concerned about how much leverage – actually borrowing – was being used by pension plans as part of their LDI strategies.
UK rules prohibit pension schemes from borrowing money to fund investments, but experts such as Ralfe and Henry Tapper, executive chairman at Agewage, have said LDI hedging schemes are the same as borrowing.
“Pension funds are not allowed to borrow money, and leverage is borrowing in my mind,” Tapper told MPs. “There is a difference between matching your assets and liabilities, which is hedging, and leveraged LDI, which is pure speculation.
“What has absolutely shocked me in what we’ve seen over the past few weeks is… hidden leverage,” he explained, referring to levels of borrowing that wouldn’t otherwise show up on retirement plans or corporate balance sheets.
“I don’t think it was common knowledge. If you look at all the information produced by the Pension Supervisor and the Pension Protection Fund … there is nothing,” said Ralfe. “If you look at individual company accounts, there is nothing there. So it was hidden.”
Iain Clacher, a professor at Leeds University’s business school, also blamed leveraged LDI schemes for the collapse of the bond market.
“If you just look at the asset side, based on the calculations that myself and Con [Keating] have done, we estimate that somewhere around £500 billion is probably missing. And this is not a paper loss. This is a real loss because pension funds sold assets to meet the collateral deposits,” Clacher said.
And while the pensions regulator has admitted to encouraging the use of hedging strategies, including LDI, experts told MPs on Wednesday that watchdogs had failed to spot the systemic risks associated with their widespread use.
The pension regulator launched an investigation into the use of LDI after the Bank of England drew attention to the schemes in its 2018 financial stability report. However, experts have said that the regulator has not properly understood the systemic risks created.
“Most importantly, there is no single numerical risk assessment in it anywhere [pension regulator] report,” said Con Keating, head of research at Brighton Rock Group.
According to the Pension Supervisor, approximately 60% of pension schemes use LDI.
Keating added that the regulator was aware of the risks before the market collapse in September and claimed the crisis was “completely predictable”, contradicting claims by watchdogs including the Financial Conduct Authority, which have also appeared before parliamentary committees in recent weeks.
However, Jonathan Camfield, a partner at Lane, Clark & Peacock defended the use of LDI, telling MPs that leverage was an important part of making sure company pension schemes could pay retirees.
He said that while leverage carried systemic risks and LDI required “some better management” going forward, these strategies were an “efficient” way to hedge against interest rate movements and inflation.
“LDI will have been a success for schemes that have been in LDI [in the] in the meantime,” he said.
The Pension Supervisor declined to comment.