LONDON (Reuters) – The recent crisis in Britain’s government bond market means smaller British pension schemes could shell out more money for a bespoke liability-driven investing (LDI) strategy in future to provide better protection, according to industry sources.
LDI products, sold by asset managers such as BlackRock, Legal & General and Schroders to pension funds, use derivatives to help them “match” assets and liabilities so that there is no risk of lack of money to pay pensioners.
Pension funds, which must post cash as collateral against their LDI derivatives in case they turn sour, were caught out in late September by a sharp rise in UK bond yields after the market became scared of government plans to fund the tax cuts through borrowing.
As pension funds sought liquidity to meet margin calls, the Bank of England stepped in to stabilize the market and prevent some LDI-exposed funds from collapsing.
Smaller private sector pension schemes exposed to LTD – those seeking to hedge up to 400-500 million pounds ($452-565 million) in aggregate assets, have typically held assets with d other schemes in pooled LDI funds, while the largest schemes have their own funds or segregated mandates.
Industry analysts say some smaller programs could now consider switching to bespoke LDI products as it could more effectively protect them from another market rout. But the higher cost will reduce their ability to invest in the higher-yielding assets that boost funding positions, they add.
According to a consultant who declined to be named, the costs of covering LTD through a bespoke arrangement for a small pension fund would currently cost around 50% more than through a pooled fund.
LDI funds have become popular as years of low interest rates have left some corporate defined benefit pension plans, which provide retirement income for millions of people, with deficits.
Of more than 5,000 defined benefit or final salary pension schemes in Britain, around 3,000 use LDI, and around 1,800 of these use pooled funds, according to The Pensions Regulator.
Mutual funds are more rigid in liquidity demands than bespoke funds, making it harder for pension plans using these funds to meet recent margin calls, industry sources say.
“There were significant advantages to having segregated accounts compared to mutual funds,” said Steve Hodder, partner at LCP, of the recent rout in UK bonds, also known as gilts.
Mutual funds are cheaper because managers have been able to pool the costs of setting up and documenting funds, but segregated funds more closely meet the needs of individual plans, he added.
“I wouldn’t be surprised if, over the coming months, we advise certain diets to make this change.”
Pub operator Mitchells & Butlers uses a separate mandate for its £2billion pension scheme and its chairman Jonathan Duck told Reuters the scheme had no problem in the recent turmoil gilts because he had “tons of cash”.
But pension schemes that couldn’t meet margin calls in time – many of which were smaller schemes – had their positions liquidated by LDI fund managers. This meant that they were no longer protected against large swings in bond yields.
The recent drop in yields has worsened their funding positions, as lower interest payments mean they have to set aside more money now to pay future pensions.
Edi Truell, CEO of pension consolidator The Pension SuperFund, said a drop in long-term yields of one percentage point could equate to “a loss of around 10%” in a scheme’s funding position. .
Larger segregated fund plans were more likely to have retained their coverages, industry sources said.
Many pension plans still want hedges, even if the positions become more expensive as LDI funds reduce leverage or borrowings, ahead of further regulatory scrutiny.
A Bfinance survey of 21 UK investors in October showed they all plan to maintain their existing LDI strategies.
However, the higher fees of a segregated fund can be beyond many plans, consultants say.
Larger plans in segregated funds pay lower fees for more volume – a benefit that smaller plans cannot take advantage of.
For example, a large LDI manager charges 4 basis points – or 0.04% – in management fees for a low-risk “passive” mandate for the first billion pounds of plan assets and 3 basis points for the next billion, said a consultant.
An alternative is a so-called “tailor-made mutual fund”.
This puts the schemes into a “single fund”, using generalized documents that make it cheaper than a separate fund, although more expensive than a regular pooled fund, consultants have said.
Fund managers LDI BlackRock and Insight Investment did not respond to requests for comment. Legal & General Investment Management and Schroders declined to comment.
However, some pension funds are reluctant to pay and are considering reducing their exposure to LDI, especially as yields remain higher than they were a year ago, reducing the risk of not being covered.
As LDI funds are expected to offer lower leverage in the future, repos will also need to tie up more of their investments in low-yielding assets such as gilts to match their liabilities.
“All of this makes LDI less attractive than it used to be,” said Andrew Overend, partner at consultants First Actuarial.
(Additional reporting by Tommy Reggiori Wilkes; Editing by Susan Fenton)
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