Around 20 years ago, UK occupational pension liabilities underwent a structural change. With assets weighted towards UK equities, still cashflow positive and open to new members and future accrual, liabilities were not too greatly discussed. 

Editor's Letter - Nov 22

First came the post millennial equity market downturn. Then came changes to accounting rules, which led many sponsors to close these schemes, first to new members and then to all future accrual. 

Recognition that the pension liabilities are in themselves bond-like led to a series of changes in investment and risk management strategies in the early 2000s, and the advent of liability-driven investing. 

Boots shifted £2.3bn (then about €3.6bn) in assets to long-dated UK Gilts in 2002. In 2003-04, the insurer Friends Provident hedged its pension liabilities in full. A first generation of liability pooled funds, essentially long-dated bond funds with some duration extension, emerged.

But locking in underfunded liabilities at low rates without upside exposure to the equity risk premium looked highly unattractive to most schemes and sponsors. Most opted to retain some form of risk exposure.

And so the modern ‘leveraged’ LDI strategy was born, essentially allowing trustees to hedge liabilities while maintaining exposure to return generating assets. 

In UK pensions there followed a wealth of risk-hedging strategies, some highly bespoke.

But leveraged pooled LDI funds, a 2.0 version of cashflow matching funds, were the tool that essentially democratised risk hedging for majority of underfunded pension schemes at that time. 

For CFOs they offered the possibility to close the funding gap gradually over time at much lower cost to the sponsor – and shareholders – than a more stringent deficit reduction approach.

In the case of a closed DB pension scheme, the effect for the sponsor is like running a captive annuity book with very little downside risk and at much lower cost than an insurance buyout.

And that all worked – for as long as it worked. In fact, until the last week of September 2022 when an ill-judged budget led to unprecedented moves in long-dated UK government bond yields. 

The fallout was immediate and dramatic, as trustees scrambled to sell assets (or even secure credit lines from sponsors) to meet margin calls. Only timely intervention by the Bank of England averted a looming liquidity crunch for some, or a pro-cyclical downward spiral in long-dated bonds.

The comparison with the Netherlands is an important one – and here there is a divergence in regulatory practice that the UK would be wise to take note of. By introducing the FTK funding regime in the 2000s, the Dutch regulator unleashed as much of a cultural revolution in pensions as it did in improving risk management practices.

In recognising early on that prudent management of pension assets and liabilities means adding complexity risk, the Dutch regulator correctly identified a governance issue at the heart of the pension system.

It has effectively engineered a reduction of the number of pension funds from the high three figures 20 years ago to about 200 today. This smaller number is better governed and the system overall more secure than it would otherwise have.

Effectively, the Dutch regulator has recognised two things – first that a smaller number of institutions is easier to oversee; and second that if there is a limited pool of available, qualified trustees, this pool is better concentrated where it can bring its skills to bear more effectively.

Compare this with the UK, where the Pension Protection Fund measures the assets and liabilities of more than 5,200 pension funds. While the problems with leveraged LDI strategies and funds were not as serious as portrayed in some sections of the media, they were real. 

Whether the root issue is product complexity, governance, risk management or some combination of the above, the UK really does need to find a way to consolidate pensions. 

As the net effect of rising rates has been to reduce liabilities, leaving most schemes well funded overall, many UK CFOs will take a look at the leveraged pooled LDI fund offering and say ‘no thanks’. This could presage a shift towards the already buoyant bulk annuity and insurance buyout market – capacity permitting. 

The interesting aspect with insurance buyouts is that this involves a shift in regulatory oversight from The Pensions Regulator (TPR) to the Bank of England’s Prudential Regulatory Authority (PRA). This might be the time for the UK’s new prime minister to consider bringing TPR under the PRA’s wing – in the interests of a holistic approach to the oversight of more than £1trn in UK long-term retirement savings. 

Liam Kennedy, Editor