by David Otudeko and Maria Busca
The dramatic increase in UK Government gilt yields last autumn brought about much commotion in the pensions world and threatened to spill over from government bonds into wider financial markets. LDI or Liability Driven Investment, a little-known investment strategy outside of asset management circles, soon made its way into the mainstream media and even everyday conversations.
What went wrong and the lessons to be learnt remain an open topic under much scrutiny, not least in Parliament. Most of the focus has been on the impact on Defined Benefit (DB) pension schemes, with little attention paid to why insurers were not affected in the same way.
Here, we’ll explain the difference, and why this episode reflects the importance of getting accurate information about pensions, understanding your pension, and the rights and options that come with different types of pension.
Putting a value on obligations
Providers of annuities and DB pensions (also known as final salary schemes) provide an income for the rest of the beneficiary’s life. Therefore, these providers have to make sure they hold sufficient assets to meet their future obligations to beneficiaries, appropriately accounting for investment returns and inflation. To calculate the present-day value of these future obligations, providers use Government bond rates (known as gilt yields) to “discount” their liabilities. Put simply, if a provider needed to pay £100 in 30 years, this would be recorded as a liability of less than £100 in today’s money, as the provider can invest that reduced amount in gilts such that it would grow to become £100 in 30 years time. This means, the lower the gilt yields, the higher their obligations appear, and correspondingly, the higher the gilt yields, the lower the obligations appear.
What happened
So, what happened in the autumn of 2022? Government gilts yields rose quickly, meaning that pension providers were able to discount their liabilities at a higher rate than before, strengthening their funding positions. Clearly, there was no issue with the solvency of these providers.
The problem lay with an investment strategy commonly used by DB pension scheme providers. To reduce exposures to market volatility, the schemes typically hedge their positions through gilt derivatives (a type of financial instrument) managed by “liability driven investment” (LDI) schemes – as much as £1tn is thought to have been invested in such funds.
And here was the root of the problem. If gilt yields go up too far and too fast, although DB schemes’ funding position improves, their LDI positions become loss-making. Therefore, they need to provide emergency collateral to the LDI funds, and may need to do this very quickly. Hence, many DB pension schemes found themselves being forced sellers of UK Government gilts, as they needed cash to meet these emergency collateral calls.
This was a problem of liquidity. This forced selling of gilts, at a time when other pension schemes were also trying to sell, put gilt prices into a downward “doom loop” that could have seen DB pension schemes running out of cash if the Bank of England had not intervened, offering to be a gilt buyer of last resort.
Why insurers weathered the crisis better
Although annuity providers have the same type of long-term obligations as DB pension schemes, value their liabilities in a similar way and hedge their liabilities against the same risks, they do have some crucial differences which helped them ride out this crisis a lot better.
As annuity providers do not have the backing of a sponsoring employer, they operate under a much stricter prudential regulatory governance and risk management framework, Solvency II. Solvency II will soon be reformed for the UK market in key areas such as the risk margin and matching adjustment eligibility and renamed Solvency UK. This framework requires firms to not only have liquidity risk and capital management policies but also specifies requirements for them to conduct an own risk and solvency assessment (ORSA). As part of the ORSA, firms must undertake wide ranging scenario analysis. This analysis would include extreme market stresses, incorporating both forward looking stress tests and reverse testing which work back from pre-determined outcomes, such as insurer failure, in order to identify what it would take to cause it.
This rules-based regime contributes to ensuring insurers’ safety and soundness even in stressed market conditions, which is very different from the principle-based regime applying to DB schemes. However, it is worth noting that the new DB funding code is moving towards a more prescriptive approach.
In addition, despite using similar hedging strategies as DB schemes, insurers do so in segregated or in-house arrangements, rather than in pooled funds which means they can be much more flexible and nimble in times of stress. The same is true of larger DB schemes. Insurers also use lower leverage compared to the levels that some of the affected schemes are understood to have used.
Accurate and clear information
The fast-moving situation led to confusion and worries that people’s pensions might be at risk. Some commentary implied (misleadingly) that ‘pension schemes were going bust’ or ‘had to be bailed out by the Bank of England’. No wonder that many people became seriously worried about their pensions and financial security in retirement. The increase in enquiries to our members and other DC schemes reflected the worries of many savers who were trying to understand whether and how they were impacted and what they could do about it. But such commentary was inaccurate for a number of reasons.
Firstly, DB schemes are promises by the sponsoring employers and cannot be avoided unless their sponsor goes bust and can no longer afford to deliver them. In such a scenario, the Pension Protection Fund, a public body, steps in and generally offers at least 90% of the employer guaranteed level.
Secondly, this was a liquidity crunch rather than a solvency issue, meaning that schemes had to find a lot of cash very quickly. They were not going bust; quite the opposite, as their obligations shrank as a result of the fall in gilt prices, and so their funding positions actually improved. Admittedly, left unchecked, liquidity crunches can deepen and put so much downward pressure on prices that they push institutions into insolvency, whereby their assets no longer cover their obligations. However, this was not a reflection of the situation at the time and the Bank of England stepped in and took effective action to stem the downward spiral.
Moreover, if these schemes could not meet obligations, their sponsoring employer would have stepped in, and in some cases they did. To eliminate the risk of being drawn into such obligations, employers sometimes decide to enter buy-in or buy-out arrangements whereby they transfer these risks to an insurer who becomes responsible for paying pensions/annuities. This is why insurers, as bulk annuity providers as well as retail annuity providers, face the same type of obligations as DB pension schemes.
The fall in gilt prices affected some DC pension savers too, but in different ways. Those who had significant portions of their investment in gilts, and made withdrawals during the fall in prices, suffered losses. However, despite the gilt market volatility, the prospective income from gilts was relatively stable, with the returns on them increasing. And those who were in the process of using their pension to buy an annuity would have likely seen their losses offset by increased annuity rates, which reached higher levels than they had been for some years.
In the frenzy of legitimate concerns as well as speculation, some of our members reported a spike in client calls and, as a result, sent explainer communications, refreshed their available information on volatility and put on webinars for consumers and advisers. Since 2015 firms have been considering if their customers are in the right investments as they head towards retirement, and how to communicate this to them. The fact that different approaches are being taken illustrates that there is no right answer without knowing what the customer will eventually do. Ideally, consumers should know what their pension is invested in and ensure that matches with their intentions. But providers often don’t know how customers want to take their income in the future.
This episode of turmoil highlights the importance of accurate information for consumers: including what kind of pension beneficiaries have, their rights, the fact that their investments may go down as well as up, the benefits this offers and the risks to which they are exposed.
The ABI and PLSA’s three-year Pension Attention aims to boost people’s understanding and engagement with their pensions. The campaign deliberately started with very simple information and calls to action for people to check their pensions. In time, we hope that this initiative will help address some of the confusion and unwarranted worries that people may have about their pensions that could in times of stress expose them to the risk of taking rushed and unwise decisions.
There are lots of angles yet to be unpicked and lessons to be learned from this crisis, from supervision and data, to regulation, risk management, operations and communication. One of them is about ensuring consumers get accurate information, are not unduly worried and know the risks to which they are and aren’t exposed; and ideally, are supported to engage early to make a plan for how to take their pension income in future. Another reason to ‘pay your pension some attention’!