Liability Driven Investments..

[shri]

An older article..

Questions, can the pensions or the bankers explain these strategies without the usual dick waving of 'this is too complicated to explain'.

The number £1.5tn is big — at least in a UK context. It is 40 per cent of the UK institutional asset management market, two-thirds of gross domestic product and about the size of the government’s total debt, after stripping out bonds held by the Bank of England.

This is the quantum of liabilities held by UK pension funds that have been hedged with so-called Liability Driven Investment trades, according to the asset management trade body The Investment Association.

The Pensions Regulator estimates that every 0.1 percentage point fall in UK gilt yields increases a conservative measure of UK scheme liabilities by £23.7bn. In the decade to December 2020, long-dated, 25-year gilt yields fell by more than 3.5 percentage points and scheme liabilities increased by £960bn (about 40 per cent of GDP).

Pension schemes can’t control wild swings in their liabilities’ value. But they are not completely helpless. They can invest their assets so that they become relatively indifferent to bond market gyrations, and this is where LDI comes in.

https://on.ft.com/3ofhzxL

[shri]

Let's start with $100 and the need to return say for example $4 to be every year for 25 years after I retire at say 65.

I assume the $25 needs to be inflation adjusted? Any other complications related to pensions that I am missing out on?

[Sith]

LDI is not the problem and even makes sense for defined benefit pensions. The problem is the hedging (excluding hedging the currency risk) and thus the chance for a margin call. Hence personally I still believe never invest with borrowed money (excluding live-in home)

[TheBrit]

There is another thread on this that contains links to several articles explaining LDI very well.

Sith is right, LDI is not a problem at all and makes perfect sense for defined benefit schemes.

The issues last week were due to gilt buyers going on strike and hence no market for anyone (pension funds, mutual funds, insurance companies, whoever) to sell their gilts in an orderly fashion. As is usual in these market dislocations, the central bank stepped in and became a buyer of last resort for a short period of time (up to two weeks).

Markets operating normally now, volatilty subsided and probably some operations departments reviewing their procedures on posting collateral.

Nothing to see here. Move along....

(the question on the UK Governments fiscal plans and the long term effect on gilt yields and sterling is another dicussion entirely....)

[sarsi]

I am frankly completely freeaking out about this for everyone. I'm freaking out because no one has noticed they've just walked right past a raging forest fire and didn't bat an eyelid. It will just sound like paranoia and fearmongering because pointing out how close you shaved past avalanche point and catestrophic systemic risk will always sound crazy until it happens but I am seriously shittin bricks when I think of this. It wasn't that long ago but everyone has completely forgotten all the pitfalls highlighted in Lehman postmortem and now openly touting them as a good idea. Of course LDI isn't the problem, it's just a name and label, it's the LDI theyre doing. I'm pointing right at the raging fire and the response is, what's the issue?

[TheBrit]

Lehmans was insolvent. The UK pensions funds had short term liquidity issues.

Say you’re a millionaire who loses his wallet and phone. This is an inconvenience and you can’t buy yourself a MacDonalds. But you’re not bankrupt, you just can’t magic up cash out of thin air to buy a burger.

It doesn’t mean you’ve lost your fortune or were ever close to doing so.

Don’t confuse solvency and liquidity.

[freeier]

I think Robroy said it rightly... the Derivatives and the value of the Gilts moved at the same direction to interest rate fluctuation, then the whole argument that this is 'strictly' hedging kind of leaked water.

Nobody will be here to declare what exactly happens, but piecing together the info and whatever written by the semi-professionals at FT.. this is what I would guess:

Assuming Pension asset collected GBP 100b.
Investment allocation, say, 60b GBP in long dated 10/20/30y Gilts/IG bonds. the rest 10b in RE+PE, and 20b in Equity.

Then, the so called 'hedge' that blew up. I reckon they overlaid a GBP 100b receive fixed IRS 'hedge' on the portfolio.
or maybe even overhedged.. say 200b or 300b.
This IRS receiving fixed will allow the funds to receive a fixed annual payment of say, 2.5% on the amount, and the liabilities are floating rate GBP on conventional basis (i think its quarterly).

Technically this hedge means the pension fund will receive that 2.5% that it needs to pay out annually.. so that locks up the required payment cash flow for the next 10/20/30 years. But the IRS actually comes with a floating rate liability that the investment portfolio would have needed to fund. During times of low interest rate, the payment flow is fine. But as the short term rate goes up, the payment flow becomes high. Which leads to the whole MTM of the IRS collapsing.

In general, the 60b of Gilt/IG in the portfolio would have been used as collateral of the IRS. Most c/p of IRS allow that.. even equities are commonly used as collateral with some haircut.

But when rates shot up? The Gilts/IG were falling in value at the same time as the IRS... so that created a situation where liquidation of the IRS/Gilts/risky assets were necessary.


So the question. Is this a 'leveraged' position or some so-called hedging.

To a laymen its can be just hedging.. (i.e. converting floating rate liabilities into fixed rate cash flow).
but if you are in the rates space you know actually the way the IRS were used syntactically creates a long-bond position. i.e. those IRS replicated investment in long dated bonds. Hence, when rates went up the IRS become negative in value (i.e. bond price fell, triggering a margin call) at the same time the Gilts/IG value fell.

If this is what actually happened, then yes, there had been leverages. Not high, depending on how much yield they were trying to generated on the long term.. if that IRS notional position was just 100b, then its just a 2x leveraged bond portfolio.

Is that going to destroy ? Well, probably not. But let's see what happens later when gilt rates move back up again.. how the short term liquidity will lead to the funding status of the funds.

[sarsi]

I think ppl need to keep their eye on this pls, do not pass go. This is the house of cards scenario, it either tumbles or it doesn't. This is management of your funds for a risk level that you do not need to take. It is just too high. Is it a good one? Surely a strategy that can trigger such market movements even when it's not solvency related that requires your BOE to step in which is again your money too can't be that great. I don't understand why I even have to say that out - your BOE and pension fund just collided with each other in a car crash because of this strategy and the guys who sold the strategy to you said it's ok and you looked at the writeups and decide yeah sounds about right. No it doesn't. What part of this is good pension management? I wish the gas ad was for this - we do not like what happened pls lower the risk. I think everyone should be trying to send your feedback in a way that can leave a quick public footprint, tweet blog tell your friends. Just build the mood that that better not happen again. FT and WSJ are not asking the questions a normal objective inquisitive mind should be asking - they've explained v clearly what happened when they should be asking why the fuck is this happening again. What was the position value that triggered the margin call and what is it now - basically what was the $ value that we lost from the pension fund? That's what pensioners would want to know but no one has asked that. BOE stepped in to buy gilts to stem the disorder - exactly how? Pension fund needs money to post collateral, so how would BoE buying gilts in market to stop yields from rising stop the margin call requirements from worsening. Complete disconnect and not enough details but the papers are not asking enough questions. Subprime was the systemic risk. The kickoff avalanche were much earlier from a handful of hedge funds that went under because of a margin call they couldn't meet. Your pension fund very much solvent and well is effectively being managed just the same as a hedge fund with the same kind of risk, albeit all for good purpose of matching assets with liabilities and no hanky panky but this is a no. Your fund value just cannot be placed in a brokerage account that can be drawn on as eligible collateral when needed.

[TheBrit]

All this about DB pension funds being 2x leveraged is just horseshit.

And all the word salad about DB funds losing on the swaps when gilts fall is spectacularly missing the point - that’s exactly what they are designed to do. This is because the liabilities of the fund are falling at the same time.

The same thing happens in reverse, when DB liabilities are rising (when gilt prices are rising) the pension fund gains on the swaps.

It’s almost like they are *gasp* trying to match the assets and liabilities to insulate the fund from swings in yields.

I guess the pension fund managers, the trustees, the pensions regulator, the FT, the WSJ and all the other journalists who have extensively covered this are all wrong and the whole system is going to come crashing down but I know where my money is.

[sarsi]

We can get into do we need this kind of hedging at all separately but I cannot believe that a regular UK citizen is ok or even has any idea that the money they put into the pension fund isnt actually going into some bank or custodian account earning interest or being used to buy long term bonds or blue chip stocks accumulating value slowly but safely. That's what most ppl assume is happening - is this not the case for UK... I don't think they know the money is being placed in essentially the equivalent of a IBKR account for the pension fund that they are using to invest in all-sorts of products, traditional derivative listed or designer OTC contracts and again all done simply to manage the fund to max returns. But does that even matter when it means your fund value could potentially be wiped out overnight if and when unexpected market condition came up? Pls just no, this is a disaster waiting to happen