Systemic risk of strategy alignment caused LDI crisis, committee hears

In the first session of the fourth formal meeting of the WPC's inquiry into defined benefit pensions with LDI - held this morning (1 February) - the committee heard evidence from people including Bayes Business School Pensions Institute director professor David Blake; independent economic and financial markets commentator Toby Nangle and Pensions & Investment Research Consultants (PIRC) head of governance and financial analysis Tim Bush.

WPC chair Sir Stephen Timms said the government actuary had told the committee that a main factor behind last year's LDI crisis was that a large volume of pension scheme assets were all aligned to the same strategy and asked the witnesses if they agreed this was the case.

Nangle said the government actuary was "absolutely right" in his analysis. He said that the volume of assets in LDI had been estimated by the Investment Association to have been around £1.6trn. He said this compares with the UK government debt total of around £2.4trn, of which about £800m is held by the Bank of England (see note below [1]).

He explained: "It is not so much like a big fish in a small pond. It is more like a tuna fish in a paddling pool and any swivelling of the tail would just destroy the whole structure."

Nangle said the sheer size of the LDI positions held by schemes could really unsettle the market in a way that was "unavoidable" as there is no counterbalance.

Blake pointed towards the historical example of portfolio insurance strategies in the 1980s where funds increased equity weightings when the markets were rising and sold them if the market was falling - something he said was a sensible strategy for individual funds but, when all funds collectively behaved in the same way and used the same triggers, led to a vicious cycle of falling prices leading to further sell instructions, themselves leading to further falls in prices.

He said this was a key driver behind the 1987 stock-market crash - adding such systematic issues were also at play during the LDI crisis last year.

Blake said: "It is the systemic risk that hasn't been taken into account. And what was sensible on an individual basis for an individual scheme, doesn't become sensible if you've got all these similar trigger points happening at the same time."

He added that this sort of systematic issue was not unusual historically - and said that rather than being the victims of the rise in rates, pension funds had actually been the cause of much of the problem as they were selling into a market with little liquidity.

Blake said: "It was entirely to do with them. Once you have big trades and the liquidity isn't there on the other side this is going to be inevitable consequence and that is something it is hard for regulators to do anything about."

He added leverage in LDI was also a big issue - something that had effectively led to pension funds acting as "shadow banks".

"We've got our sleepy little pension funds, classified as shadow banks, and they have been responsible for this particular issue as a result of these LDI strategies."

Nangle added that Dutch pension schemes invested in a similar way to UK funds but had been less impacted as the size of the Dutch pension system did not make up as big a proportion of the European bond market as UK schemes did in the UK bond market.

He said: "[The Dutch system] just wasn't big enough to cause this systemic issue. It is about the ratio of the size of the sets of schemes all doing similar things and the size of that market that they operate in."

Equity to bond switch

Timms also asked the witnesses why defined benefit schemes had largely switched from equities to bonds over the past 20 years and whether that was an issue to be worried about.

Nangle told the committee the move was principally the result of the move to mark-to-market accounting in the early 2000s and the Pensions Act 2004, the legislation that gave rise to both The Pensions Regulator and the Pension Protection Fund.

He said: "Those two things together created an imperative for sponsors and schemes to more closely align the present value of their assets with the present value of their liabilities and one way of doing that is by moving assets from equities, which should deliver strong long-term returns, but are very uncorrelated with bonds, towards something more bond like so that there is a smaller degree of mismatch."

Nangle said the knock-on impact of this was there was a rise in the amount international investors were holding in UK equities and a rise in international takeovers of UK businesses.

He added: "I think over the past years or so about a third of FTSE 100 companies have disappeared, and about 70% of those by value have gone to international buyers."

Conversely, he said the regulatory framework effectively meant that pension funds had "financed the UK government" and reduced the cost of borrowing for the exchequer, a potential public good. But he said equity benefits had largely dispersed overseas.

Blake said an additional reason for the shift from equities to bonds was the increasing maturity of pension schemes.

He said: "Pension funds have matured as they have closed to new entrants and, in many cases, they are much more concerned about paying out pensions than they are about growth."

But he said the switch from equities to bonds was bad for the economy.

Blake said: "Despite the fact that we have the biggest pool of long-term assets in pension funds in Europe, they have not gone into companies, there has been no research and development, and there has been no capital investment, to increase the productivity of UK companies... Our pension funds haven't done the job they could have and should have done, which is channel those long-term savings into long-term investments in long-term capital and long-term improvements in productivity."

PIRC's Tim Bush said accounting standards had "frightened companies" into changing allocations - adding the regulator, taking the same approach, had effectively been frightened by the same thing.

He added: "I think it has clearly been extremely harmful because the biggest supplier of capital to UK companies has been withdrawn over a 10 to 15 year period."

[1] PP readers have pointed out that, while the notional value of LDI had risen to £1.6trn in 2021, not all of this LDI is physically held government gilts - adding that, according to Office for National Statistics / Bank of England figures contained in HM Treasury's Debt Management Report 2022-23, insurance companies and pension funds held  27.4% of the UK government's debt.