Amundi Pension Funds Letter - Special Edition: UK LDI Crisis

Summary

Editorial

UK LDI crisis. Implications for European corporate pension funds

Given the yield increases at the announcement of the UK accommodative mini-budget a week ago, pension schemes suffered a massive liquidity crisis related to their leveraged LDI strategies. This drove the Bank of England to temporarily halt Quantitative Tightening.

Yet rather counterintuitively, pension schemes have never been better positioned as their funding levels are higher than ever. This was such a severe event that it certainly contributed to UK Prime Minister Liz Truss’s announcement on Monday 3^rd October: she will partially reconsider her government tax cut plan.

The events that unfolded in the UK, whilst dramatic, are unlikely to be repeated in the exact same manner in the rest of the world:

UK pension fund investments represent around 120% of GDP¹ , unrivalled across other economies (with the notable exception of the Netherlands, which, in contrast, can use the whole Euro market for its investments), which lead to a concentration of government bond ownership that is much higher in the UK.
The leverage characteristics of LDI are unique to the UK: use of repos and pooled strategies with high leverage are not common in the rest of the world. Pension schemes investing in pooled LDI strategies were unprepared: they had to find swiftly assets to meet the demands of their LDI managers who have no direct access to the rest of their portfolios.
Adoption of LDI is mainstream for UK Pension schemes, more so than in many other countries.

Nevertheless, there are still some lessons to be learned for pension funds across the world:

a. Review your liquidity stress test.

b. Adapt the leverage strategy to the environment: more volatility in rates should lead to higher liquidity buffers and to looser LDI constraints (e.g. lower leverage targets).

c. Be careful what you call liquid: darling assets of the last decade are not liquid and cannot be relied on for liquidity purposes. Be careful what you call LDI: illiquid assets with long duration characteristics have behaved very differently relative to typical LDI assets.

d. Be prepared to find innovative liquidity solutions: act now to be ready should you need to exchange your liquid assets for cash whilst keeping some growth asset exposure.

e. Assess if it’s time to reconsider LDI size: the current environment might actually be a good entry point for more LDI strategies. With the increase in funding ratios, glide path strategies recommend an increase in liability hedging.