Many pension schemes and trustees might feel the gilt crisis is now in the rear-view mirror, but its impact has forever altered how schemes navigate their responsibilities
At a Professional Pensions roundtable in May - held in partnership with Columbia Threadneedle Investments - experts gathered to discuss how investment strategies have changed in light of the crisis and how schemes are changing their portfolios and approaches to liquidity.
At the heart of the gilt crisis from a pension scheme perspective is liquidity.
Following the mini-Budget - which was predicated on significant tax cuts, funded by amplified government borrowing - investment markets were spooked, in turn causing gilt yields to spike and prices to fall. While pension schemes' liability-driven investment (LDI) portfolios continued to move in lockstep with liabilities, hedging interest rate and inflation risk, the rise in yields required LDI managers to call additional collateral from the schemes in order to maintain those hedges. However, the unprecedented speed of the market moves meant that some schemes struggled to provide additional cash within the often-short timeframes required, resulting in a reduction in hedging.
As such, the panel discussed how schemes had been readdressing their portfolios from an LDI, buffer and liquidity standpoint.
"You are maybe seeing a tilt in those LDI portfolios to include more credit bonds," says Capital Cranfield professional trustee Mark Hedges.
He adds that some schemes had needed to change their strategies either to maintain their hedging, or where hedging had been reduced, "people will have sold their liquid assets to rebuild the buffers".
"Those who have done that, coupled with the movement of rates, have probably seen liquid asset allocations fall, and are now stuck with a pool of illiquid assets that they will have to run down over time."
Dalriada Trustees professional trustee Judith Fish agrees - noting there will be some schemes that did not do as well and still need the same level of return.
She says: "They are going to have to think quite carefully about how they get that return, because they could end up, if hedging levels are maintained, having to take much more risk than they would ordinarily want to take in the rest of the portfolio."
BESTrustees trustee executive Michelle Darracott says operational awareness in terms of the distinct parts of a DB portfolio also appears to have risen as a result of the LDI crisis.
"Helpful things usually come out of a crisis, and now there is much more industry guidance for fund managers in terms of the size of collateral buffers that they have to keep," she says.
"And the same conversations are being had in a slightly different context, such as the extent to which you manage your diversification across investment managers versus limiting your liquidity risks, around drawing down on your liquid assets in the event that rates go up, and around hedging."
The Bank of England's Financial Policy Committee (FPC) recommended to The Pensions Regulator (TPR) in March this year that it specify "minimum levels of resilience" in relation to pension schemes' liability-driven investments to avoid feedback loops being created by large numbers of schemes being forced sellers of assets.
The FPC stated the level of resilience required should be able to absorb a gilt yield increase of at least 250 basis points, lower than the 300 basis point minimum that TPR recommended in its November 2022 guidance.
Columbia Threadneedle Investments UK head of solutions Simon Bentley says his firm has been communicating with clients that the 250 basis point or 300 basis point figures were "only a subset of the bigger picture".
"The target level of headroom could be 400 basis points, so you only have 100 basis points before you could be called for capital to maintain the headroom," he explains.
"We're helping clients understand this process, decide how much headroom they may wish to hold outside the LDI portfolio, and then looking at the liquidity of the assets that they are focusing on, emphasising that assets have to be daily dealt and have short settlement cycles."
While many schemes will no doubt still have jobs to complete on their ‘LDI 2.0 readiness to-do' list, Zedra professional trustee Colin Richardson thinks there had been rapid progress by schemes and managers.
"By the time the main guidance had been published in March, LDI managers, investment consultants, and pension schemes, were, generally speaking, already doing the entirety," he says.
"Schemes were moving, rightly, well ahead of the actual formal guidance from the regulator, albeit formal guidance is very helpful. But it's important to remember that 250 basis points is the minimum, plus operational buffers on top of that, so they are substantive buffers."
Columbia Threadneedle Investments director of institutional business James Edwards agrees that scheme stakeholders are now much more focused on the operational mechanics of various processes, such as how cash flows around the mandate.
"This is where people need to delegate some of their operational heavy lifting to the LDI manager," he says.
"We were extremely impressed with how quickly trustee groups turned around instruction letters [during the gilt crisis] but I don't think anybody wants to go through that again.
"So, if you can decide up front what steps you wish to take in various scenarios, and then put them on autopilot to a certain extent, that could be beneficial."
While outsourcing certain functions to the likes of OCIOs or fiduciary managers was something the panel broadly expected to see more of, the subject of buyouts also featured strongly.
Vidett trustee director Martin Collins explains his firm's specialist unit that engages in risk transfer work and takes schemes to buyout was seeing "an awful lot of business right now".
"With most of these clients we are revisiting the long-term strategy, and whether it is a buyout, and that is coming in a lot," he says.
"As soon as interest rates started going up, schemes that we thought were ten years away and had no interest in a buyout in the near future were saying ‘here's a cheque, let's go for it'".
Regardless of who controls which aspect of a scheme, though, every stakeholder must consider liquidity of the underlying holdings.
Liquidity is multifaceted, as not only could there be various parties that have to make decisions about when to sell assets, but even once the decision is made, a trade must be settled before any cash is received.
Even if an asset class is notionally liquid, if a smaller pension scheme is trying to trade via an investment platform, that platform might not offer daily dealing and/or quick settlement times.
Columbia Threadneedle's Bentley says that underlying assets need to be liquid and daily tradeable.
"Not just daily tradeable, though, but with low dealing costs and relatively low volatility as well," he says.
He notes that equities were liquid but their volatility meant that a lot of market-timing risk was embedded in them if they were being used as collateral.
"We are tending to see clients hold traditional liquidity fund units and short-dated corporate bonds," he says, adding that shorter-dated credit usually possessed more liquidity with lower dealing costs than its longer-dated sibling.
"Non-daily-dealt funds are almost dead in the water," he adds. "Why would any pension scheme consider a non-daily-dealt fund as part of a collateral waterfall?"
Given schemes need to deal with this question, and many others, the panel agrees that it is important for robust stress-testing to be undertaken to help provide protection in the event of another crisis.
Vidett's Collins says that schemes need to participate in operational risk testing, something common among the banking community.
"It is simply saying, ‘if this happened again, what would we do and when?' and you run various tests," he says.
"It is a scenario test looking at something like if rates rise again, what would be sold, who does the selling and when, and who needs to consult whom."
BESTrustee's Darracott highlights that not all pooled funds, which often serve multiple small to medium-sized pension schemes, are daily dealing, and that scenario testing in this regard could be extremely important.
With such considerations lumping pressure on schemes, some of the panelists thought that outsourcing the responsibility to a fiduciary manager could be a sensible idea.
"There are some advantages to that," says Zedra's Richardson. "Some schemes have conscientiously moved to doing that, if it was fairly straightforward to do."
Capital Cranfield's Mark Hedges agrees, but notes that it depends on the individual scheme, its size, and where it is on its journey.
"It's really about governance to a large degree, and how quickly trustees can react," he says.
"They have to decide whether it is better to delegate a lot of those actions."
The panel agrees, though, that trustees could view outsourcing as a double-edged sword; it potentially alleviates the burden on the board, but the board could still face the ire of scheme members if the outsourcer puts a foot wrong.
"It's a very interesting point about trust in fiduciary managers," Columbia Threadneedle's Edwards says.
However, he adds that larger schemes, in particular, are increasingly seeking to outsource part of the process.
"What we have seen in the last couple of years, in the scenario where a large scheme has a portfolio of LDI and illiquid assets with maybe eight years left to run, is for them to outsource to investment managers in an OCIO-type arrangement," he says.
Dalriada Trustee's Fish adds that fiduciary management is compelling for other reasons - including operational ones, such as management of data coming from asset managers.
"Fiduciary managers probably had better access to data than trustees had [during the gilt crisis]," she says.
"And another important factor is that fiduciary management has become cheaper over time, which makes you think some schemes, for a mixture of reasons including the governance burden and TPR's forthcoming General Code, will make fiduciary management look like a sensible option."
Related to this is the issue of sole corporate trusteeship, demand for which Zedra's Richardson says had "heightened" due to the ability of professional trustee firms to manage costs and lead on the process.
Dalriada Trustees' Fish agrees that sole corporate trusteeship is "probably a lot more efficient" as firms like hers focus on high-quality governance for multiple clients.
Furthermore, once sponsors close their DB schemes to new members, it can be difficult to appoint people internally for trustee roles.
"Frankly, they get to a point where nobody is attached to this fund, and the senior executives have moved on," says Capital Cranfield's Hedges.
"It is really about how they best manage it, and if they have not got that commitment from staff to want to be part of it, you have got a shortage of employer-nominated trustees, and a corporate trustee becomes an easy way of trying to manage this."
The gilt crisis has forced schemes to engage in self-reflection, with the tumultuous event puncturing the relative serenity that had been experienced since the global financial crisis.
Trustee boards have big decisions to make, and new or different hurdles to jump; some will take control of these themselves, possibly with the help of systems or tools from external providers, while others will outsource some responsibilities entirely.
Regardless of the approach taken, though, cost and the outcome for scheme members must be front of mind.
Vidett's Collins says: "You do not want to be caught a second time, but you also do not want to overpay for a solution, because this increased collateral environment is perhaps safer for the system, but it is imposing extra costs on pension schemes, and sometimes more than is needed."
Essentially, governance is key.
"Where there were better outcomes [after the gilt crisis], it ultimately came down to being better governed," says Columbia Threadneedle's Edwards, adding that where schemes suffered more, governance issues could be identified before the gilt issue kicked off.
His colleague Bentley agrees that governance should be at the forefront of trustees' minds, but alongside headroom and liquidity.
"If you think about those three things, you will have a pretty good solution," he says.
This roundtable was held on 18 May 2023 in association with Columbia Threadneedle Investments