The Bank of England’s emergency bond-buying last week helped shore up U.K. pension funds and threw a spotlight on a popular strategy among corporate plans known as LDI – or liability-driven investing.
Total assets in LDI strategies in the U.K. rose to almost £1.6 trillion ($1.8 trillion) at the end of 2021, quadrupling from £400 billion in 2011, according to the Investment Association, a trade group that represents U.K. managers. Many LDI mandates allow for the use of derivatives to hedge inflation and interest rate risk.
Here’s how LDI works: Liability-driven investing is employed by many pension funds to mitigate the risk of unfunded liabilities by matching their asset allocation and investment policy with current and expected future liabilities. The LDI portion of a pension fund’s portfolio utilizes liability-hedging strategies to reduce interest-rate risk, which could include long government and credit bonds and derivatives exposure.
Jeff Passmore, LDI solutions strategist at MetLife Investment Management, said the situation with U.K. pension plans “has been challenging, and the heavy use of derivatives in the U.K. LDI model has made the current situation worse than it would otherwise be.”
While most U.S. LDI portfolios rely on bonds rather than derivatives, ‘”those U.S. plan sponsors who have leaned heavily on derivatives and leverage should take a cautionary lesson from what we’re seeing currently across the Atlantic.”
The U.K. pension debacle “is a plain-and-simple problem of leverage,” Charles Van Vleet, assistant treasurer and chief investment officer at Textron, said in an email.
Many U.K. pension plans were interest rate-hedged at 70%, while also holding 60% in growth assets, suggesting 30% leverage, he said. The portfolio’s growth assets have lost around 20% of value if held in public equities and fixed income or about 5% down if held in private equity, he noted.
“Therefore, to make margin calls on their derivative rate exposure they had to sell growth assets – in some cases, selling physical-gilts to meet derivative-gilt margin calls,” Mr. Van Vleet said.
“The problem is worse for plans who gain rate exposure with leveraged ETFs. The leverage in those funds is commonly via cleared interest rate swaps. Margin calls for cleared swaps can only be met with cash – not posted collateral. Therefore, again selling physical-gilts to meet derivative-gilt margin calls.”
BRIAN CROCE COURTNEY DEGEN PALASH GHOSH ROB KOZLOWSKI
Dow Inc., Midland, Mich., will freeze the benefit accruals of its U.S. pension plans at the end of 2023, increase its matching contribution in its defined contribution plans and will contribute $1 billion to the pension plans before the end of the first quarter.
The chemical company announced its plans in an 8-K filing with the SEC on Thursday.
First, Dow will freeze benefit accruals for participants in qualified and non-qualified pension plans, including the Dow Employees’ Pension Plan, the Union Carbide Employees’ Pension Plan and the Dow Chemical Co. Executives’ Supplemental Retirement Plan-Supplemental Benefit, effective Dec. 31, 2023.
The average funding ratio of 19 U.S. publicly listed corporations with more than $20 billion in global pension fund liabilities totaled 86.2% at the end of 2020, up from 84.9% at the start of the year, according to a report from Russell Investments.
Strong investment returns offset a decrease in the discount rate of more than 70 basis points that brought the total liabilities of the club to more than $1 trillion for the first time, said the report released Tuesday.
Assets for the “$20 billion club” totaled $901.9 billion as of Dec. 31, up 8.6% from the start of the year, and projected benefit obligations totaled $1.05 trillion, up 7.3% from the start of the year.