Dalriada Trustees director David Fogarty
The liability-driven investment (LDI) crisis has caused ripples in the pensions market and trustees are taking a step back to reassess the viability of LDI products and take stock of what happened and why.
The defined benefit (DB) pensions sector was at the centre of the LDI crisis last week that caused a liquidity squeeze and forced the Bank of England to start temporarily buying long-dated gilts.
Some professional trustees have told PP that it is important to reassess the viability of LDI products in this new cycle, while understanding of LDI needs to increase.
Dalriada Trustees director David Fogarty says investment consultancy advice "needs to improve" and trustees need to have a better understanding of how LDI works.
He says: "Do trustees fully understand what they've invested in and what the shortfalls are? Have investment advisers given good advice around LDI, are fund products fit for purpose? It's a combination of those three things - in my view there's a problem in all three areas and they all need addressing."
He went on to say that trustees need to have the relevant skills but also the time to deal with things.
"Trustees working on a quarterly meeting cycle will have been really challenged trying to deal with what they had to deal with last week," he says.
The value-at-risk (VaR) model has been one of the most common risk measures used in the industry for the past decade or so. Advice from consultants has said that when schemes increase their hedge ratio, their VaR ratio falls, and then in turn reduces the scheme's risks.
Fogarty says this has been a "lazy approach to strategic advice" for UK DB schemes, and adds: "VaR isn't right or wrong - however the conclusion that if I have a 90% hedge ratio, my risk will be lower was wrong, because it did not factor in what would happen if interest rates go up - i.e. where I am going to get the collateral from? And because schemes wanted high hedge ratios, asset managers created products with high leverage."
Independent Trustee Services director Dinesh Visavadia agrees that understanding of LDI needs to improve, pointing out that while it has worked in the past few years, it is time to review it to see if it is still appropriate.
"Trustees need to take a step back and understand LDI products better, and maybe think harder of how we think of the risks," he says. "LDI is not the golden egg that we all thought in the past, and this is an awakening call for pension schemes to think harder and ask very detailed questions, and also the advisory role to step up and explain to us about more holistic solutions."
All trustees do a good job but "need to raise their game", says Visavadia, because some of the products trustees need to deal with require a lot more understanding of technical details.
He explains that now we are entering an increasing interest rate cycle, the question then becomes: ‘Is LDI still appropriate?'
"Trustees need to understand how it works very clearly - so who are the parties and what are their roles, and how quickly will each party start saying we now need money or we don't need money. What role do they play in trying to stabilize the whole product itself? I don't think we have seen that conversation much."
He also thinks there has perhaps been an "over-reliance on the advisory community", and that the situation has changed since schemes implemented LDI strategies: "We were in a situation where we had downward interest rate cycles, so we thought we're hedged and therefore the funding is protected.
"But our funding levels are also determined by assumptions, so if you choose different assumptions, your funding level is different. Your cash flows could be out of date by three years or more, and also your inflation assumptions are quite different."
Visavadia doubts that there are many schemes who have prepared cash flows to readdress the liability benchmarks on the LDI programs.
It comes as many schemes have been forced to sell growth assets to meet their margin calls for their LDI portfolios.
"In the last five or six years, illiquidity has become the flavour of the month but now you're stuck with that illiquidity premium because you can't sell anything," says Visavadia. "These are very important challenges that I think the advisory work community needs to bring to us as trustees, and to help us to understand.
"Selling just one side of the story is not enough - saying that illiquidity premium gives you a return to fill your deficit. Yes, [it can] but it could also bring some negative consequences, which haven't been addressed in the past."
For Pan Trustees chairman Steve Delo, good investment consulting is a critical advisory input for a pension fund trustee board, and will be essential in the coming weeks.
He says: "Trustees need investment advisors that have the resources to research well and understand a problem and then frontline consultants that can take that research and articulate it clearly to trustee boards in a way that is actionable. This sort of advice will be vital over the next couple of weeks.
"The intellectual part of consultancies will be chewing through emerging data and commentary and considering the implications of where the risks - and opportunities - move to. Clearly, a lot is happening, so advisory organisations need to get their frontline consultants absolutely on point and proactively out with their clients. This will naturally be challenging across large numbers of clients."
