The rise of liability-driven investments (LDI), pairing cashflow-matching assets with forecast liability streams, has developed in tandem with a broad, overall maturing of the liabilities of the European occupational pension sector. Overall population ageing has been one key driver: maturing schemes need more cashflow matching than those with younger membership profiles. 

In the Netherlands a strong regulatory focus on risk management and the introduction of the FTK prompted a widespread shift to interest rate swap strategies. In the UK, the shift to LDI was prompted by the widespread closure of defined benefit (DB) schemes from the 2000s onwards, a development itself partly prompted by the balance sheet volatility of liabilities brought about by the adoption of mark-to-market accounting through IAS 19. The structure of UK pension liabilities and the requirement for limited price inflation also spawned demand for inflation-linked swaps.

Banks and asset managers saw a business opportunity as these developments crystallised and LDI was born. Although the advent of pooled LDI funds initially led some to see this as a mass-market, off-the-shelf business, shifts in pricing of swaps and repos versus government bonds over time have led to a change in the understanding of LDI and risk management generally, such that it is seen much more as a dynamic process requiring time and governance resources.

In the aftermath of the 2008-09 crisis, the participants at the Pittsburgh G20 summit agreed on a clear agenda to strengthen the global financial regulatory system. Part of this agenda, as outlined in the leaders’ statement, included an agreement to shift trading of over-the-counter (OTC) derivatives to exchanges or electronic trading platforms.

In Europe this led to EMIR in 2012 – the European Market Infrastructure Regulation – and a flurry of communication and education by pension representative groups with a view to securing a three-year exemption for pension funds from the central clearing requirement, pending a suitable technical solution from central clearing counterparties (CCPs) to allow pension funds to post high-quality assets such as government bonds for the variation margin component of the collateral. 

Last year the European Commission extended the exemption for a further two years, but stated that pension funds should ultimately be required to use central clearing for derivatives transactions. As of today, no such solution exists that would allow pension funds to post non-cash assets as variation margin with a CCP.

In a recent open letter to the EU’s commissioner for financial services, Jonathan Hill, three Dutch pension institutions, APG, MN and PGGM, and Insight Investment, one of the UK’s largest LDI specialist asset managers, call for the development of a “robust solution” that would allow pension funds to post government bonds as variation margin collateral with CCPs. They note that any future collateral transformation service would require policymakers’ support in stressed market conditions. The authors also note that bank capital adequacy rules are also making repo business and that bid-offer spreads are widening. 

Legislators and politicians did not anticipate the way Basel III capital adequacy rules, in the form of bank leverage ratio and net stable funding ratio requirements, are simultaneously prompting banks themselves to restrict derivatives trades that are collateralised in cash variation margin.

While clear communication, understanding and goodwill can bring about positive shifts in policy, unintended structural shifts in banks’ risk-taking abilities are arguably more of a concern to pension funds seeking to hedge risks. As liabilities mature and pensions shift to defined contribution arrangements, the management of these risks will only become more important. Perhaps it is time for the industry to make its voice more loudly heard.