A year and a half ago this month, the UK faced a serious political and financial crisis centered around pension plans and Government bond yields.

The government at that time announced a surprise fiscal stimulus plan which included tax cuts and a freeze on energy bills. This policy plan came as the Bank of England was about to begin quantitative tightening to combat soaring inflation, resulting in contradictory policy between the central bank and the government, which sent UK government bond (“gilt”) yields soaring. 

This precipitated a crisis for many UK-based Defined Benefit (“DB”) Pension plans.  With many DB plans closed and mature, plan sponsors increasingly adopted a Liability-Driven Investing (“LDI”) approach and shifted their asset mix away from equity towards fixed income.¹ 

At this point it’s helpful to draw a distinction between “plain” LDI and leveraged LDI. The advantage of pursuing a LDI approach is its ability to reduce risk for a plan as investment assets more closely match the liability profile of the plan. However, because an LDI approach typically means a higher allocation to fixed income assets (often government bonds) instead of “return seeking” assets, the expected returns of the plan are lower, presenting a challenge for plans that are underfunded.

With the blessing of the UK regulator, many UK plans solved this problem by pursuing a leveraged LDI approach. They started by investing money in government bonds to match the liability profile. However, they then pledged their bond positions as collateral to raise cash to then invest in return-seeking assets like equities, real estate, absolute return funds. Under such an arrangement, the plan is borrowing money to buy assets which don’t match liabilities, hoping that the gains will increase more than the value of the liabilities. While this can close the funding gap, it is riskier approach for plan members.

This sudden and dramatic move in UK gilt yields in late 2022 led to a vicious cycle for many plans using a leveraged LDI approach. Higher bond yields mean lower bond prices, so these plans received margin calls from their leverage providers and they had to sell liquid, qualifying assets – in other words, UK government bonds. This selling pressure sent yields higher, meaning plans needed to sell more bonds, which precipitated a downward spiral in prices.

A short-term fix with longer-term implications

This turmoil in the gilt market ultimately led the Bank of England to hit “pause” on the quantitative tightening policy and instead begin gilt purchases on the grounds of financial stability in late September 2022. The aim was to break the cycle of falling bond prices and to enable LDI funds to build their capital positions. This policy response worked as intended, and in fact, the Bank of England was able to unwind all its bond purchases by January 2023.

Regulators and the UK Treasury are still trying to figure out how to prevent such a situation from happening again through an ongoing parliamentary investigation. One thing is for sure – increased regulatory supervision for pension plans. Because DB pension plans are not deposit-takers, they have historically not been subject to regulation in the same way as banks. However, given the need for the Bank of England to intervene, clearly these non-bank financial institutions pose somewhat of a systemic risk for the financial system due to the use of leverage. Where leverage is employed, proper liquidity management is also critical, especially when there are highly concentrated positions, which exacerbate the risk. Going forward, regulators need more transparency and oversight into how plans are managing leverage and liquidity.

Closer scrutiny from the regulators will have to be combined with more thorough stress tests. Prior to the crisis, the Financial Policy Committee of the Bank of England did perform a stress test for DB pension plans, but the stress scenario was defined as a +100 bps interest rate shock. In practice, the stress test proved inadequate as interest rates moved significantly more than this in September 2022. Regulatory guidance has already been updated so DB plans using LDI now need to withstand a 2.5% rise in gilt yields. We expect further stress tests to be introduced by the regulator to test the resilience of the sector to unforeseen shocks.

Aside from the regulatory response, the market adapted quickly after the LDI crisis in a couple of key respects. Following the crisis, many leverage providers broadened the list of eligible collateral that can be posted to obtain leverage. Typically, this meant including investment grade corporate bonds and non-sterling government bonds as permissible securities. Part of the problem with this crisis was the limited options plans had when it came to raising cash to meet margin calls, which would have given plan sponsors more choices during the crisis period. Anecdotally, we also understand that many plan sponsors have increased minimum cash buffers and looked to reduce leverage at the portfolio level while smaller plans have been cutting back on leveraged LDI altogether. This response on the plan side will also reduce overall leverage and risk in the sector.

Are Canadian plans at risk?

LDI strategies are increasingly used in Canada as elsewhere across the globe, but it’s important to draw a distinction between LDI (which is risk-reducing) and leveraged LDI (which can be risk-enhancing). The good news is, in Canada, leveraged LDI strategies are less common than they are in the UK. There are a few reasons for this. On average Canadian plans have historically been better funded than UK plans, meaning less pressure or need for plan sponsors to contemplate using leverage to close the funding gap.  

Canadian plans have also become more “liability aware” over time, but generally without moving to a full LDI approach. As a result, Canadian plans have a much lower weight allocated to government bonds than plans in the UK have for example, so they do not feel the same need to enhance risk in their portfolios through taking on more leverage like their British counterparts. 

When a leveraged LDI approach is used in Canada, it tends to be employed by the “mega” plans who have large investment and risk teams and a sophisticated understanding of risk and liquidity management. In contrast, leveraged LDI was employed in the UK by DB plans of all sizes. That’s not to say these very large plans can’t make missteps, but in general, we believe they are better positioned to analyze and understand the myriad of risks lurking in their portfolios. 

Lessons learned for Canada

While we don’t expect to see a similar LDI crisis here in Canada, the UK’s experience has had an impact on the actions and approaches of Canadian DB plans. From a governance perspective, there has been increased scrutiny of leverage and education around how leverage is used in the plan and what checks and balances are in place. In the same way that regulatory stress tests have become more punitive in the UK, we understand Canadian plans are themselves conducting additional stress tests to account for the fact that long-term interest rates can be more volatile than expected.

It is clear from our discussions that plans are re-testing their liquidity assumptions as another input into their asset mix and leverage decisions. Scenario testing of various market conditions can be a helpful input into the decision-making process, as long as it is tied back to cash requirements. Institutions should be and are increasingly asking, “hypothetically, would we have enough access to cash or short-term marketable securities to continue making our payments if the market drew down 10, 20, or 30% over a 10-day period?” 

Finally, when it comes to complexity in the portfolio (from leverage and/or derivatives), many plans have reverted to a “less is more” approach. They are asking important questions like, “is there a way to achieve my desired portfolio exposures with a reduced reliance on derivative overlays? Does it still make sense to be allocating to private asset classes versus public asset classes given relative valuations and the need for portfolio liquidity?” We believe plan sponsors will continue to ask themselves questions like these and many more to better position their portfolios.

Conclusion: An avoidable warning

The UK LDI crisis was entirely avoidable and resulted from a serious policy “own goal.”  However, it served to highlight significant risks for UK DB pension plans pursuing a leveraged LDI approach. While we don’t see a systemic crisis of this type occurring in Canada, domestic plans have taken notice and have learned some valuable lessons that should serve to increase the resilience of the Canadian DB sector.

1 The share of equity investments in DB fund assets declined from about 61% in 2006 to about 20% in 2022, while the share of fixed income investments increased from 28% to 72% (Source: IMF).

The information herein is presented by RP Investment Advisors LP (“RPIA”) and is for informational purposes only. It does not provide financial, legal, accounting, tax, investment, or other advice and should not be acted or relied upon in that regard without seeking the appropriate professional advice. The information is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does RPIA assume any responsibility or liability whatsoever. The information provided may be subject to change and RPIA does not undertake any obligation to communicate revisions or updates to the information presented. Unless otherwise stated, the source for all information is RPIA. The information presented does not form the basis of any offer or solicitation for the purchase or sale of securities. Products and services of RPIA are only available in jurisdictions where they may be lawfully offered and to investors who qualify under applicable regulation.

Liam O’Sullivan, Principal and Co-Head of Client Portfolio Management, RPIA

Liam O’Sullivan is a Principal and Co-Head of Client Portfolio Management at RPIA in Toronto.  In that role he leads business development, product development and relationship management for the institutional channel. Prior to joining RPIA in 2009, he was Chief Risk Officer at Northwest Investment Management in the UK.  Liam has a Master’s degree in Politics, Philosophy, and Economics from Oxford University and a Master’s in Economics from the University of British Columbia. Liam is a CFA charter-holder and is Vice Chair of the Executive Committee of AIMA Canada.