UK pension scheme sponsors and trustees should prepare for urgent intervention to protect their schemes, as bond markets brace themselves for historically high levels of volatility, Aon has warned.
Calum Mackenzie, partner at Aon Investments, said that with yields rising and values falling, many schemes have already had to post extra collateral for their liability-driven investment (LDI) strategies, as LDI managers have been forced to demand a collateral top-up.
He said that as they navigate this new form of volatility, many trustees have had to react quickly, in some cases needing to sign instructions that transfer large amounts of money at short notice.
The situation has arisen because the bond market has repriced rapidly – with, for example, long-dated government bonds down by around 25% this year – largely because of concern over inflation and how it can be controlled by central banks.
But many LDI solutions use leveraged government bonds to match liabilities, so a fall in the value of the underlying bonds means that more collateral is required – in effect, a margin call.
Mackenzie continued: “The challenge we are seeing for pension funds, especially those in pooled LDI arrangements, is whether they can transfer collateral quickly enough. If trustees can’t fulfil the collateral call, their LDI managers will be forced to cut their hedge, which would expose the scheme to the interest rate risks they were aiming to eliminate. “
And he said that if market movements became even more volatile, schemes would lose their hedge and become victims of yields – meaning their liabilities would shoot back up, while their assets would not keep pace.
For those with a planned collateral management strategy, Mackenzie said the last few weeks have been less stressful, although instructions have still been needed at short notice.
Turning to the scheme sponsors, Mackenzie pointed out that the situation is adding extra complexity and risk at a time when sponsor companies need to focus their attention on managing their core operations.
“Therefore, pension fund trustees and their sponsoring employers need to be properly informed and prepared for more urgent interventions,” he warned. “At a minimum, a stress-tested and planned collateral strategy is essential as preparation against further volatility.”
But he added: “For many trustees, this won’t be enough. We advise them to consider how delegating responsibility for managing the operational risks of their liability hedging strategy could reduce their risk, and allow more time for better, more strategic decisions to be made.”
Paras Shah, head of LDI at Cardano, said: “Clients of ours that utilise pooled LDI funds with external managers have experienced a constant stream of collateral calls this year which has often required prompt action to ensure hedging levels are not reduced during the process of transferring cash to the LDI funds.
But he added: “Given our fiduciary management set-up and the governance efficiencies which that brings for our clients, we have been able to meet all the required collateral calls without requiring further action from our clients.”
Shah said pension schemes without a fiduciary management arrangement in place should work with their advisers to monitor the impact on their portfolios from market shocks and ensure a suitable liquidity waterfall is in place to determine the order in which assets should be disinvested to meet collateral calls in these volatile markets.
He said: “For pension schemes who utilise pooled LDI funds, a prudent course of action is quite likely to result in holding excess levels of cash to ensure hedging levels can continue on an uninterrupted basis. However, this can lead to a return drag for many schemes.”
He added: “For schemes of sufficient size – typically with assets of around £100-150m or above – we are strong advocates for a segregated approach to LDI. This offers much more flexibility on managing collateral and avoiding the need to rush around for cash or hold excess cash.”
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