Three years on from the LDI crisis, has the UK pension industry learned its lesson?

It is three years since the so-called "mini budget". This was the Conservatives' growth plan for 2022. The budget sent shock waves through financial markets, particularly the pension industry. We will examine whether three years on from the LDI crisis, the UK pension industry has learned its lesson.

What is LDI?

In the UK, LDI stands for liability-driven investment. Corporate defined benefit pension schemes typically use it for asset-liability matching. This means the schemes look to match the duration of pension assets and liabilities. Normally, in an LDI fund, a single pension or a group of pensions invests capital. The LDI fund will then borrow funds to purchase gilts.

Regarding the LDI balance sheet, the liability consists of

• Capital from the pensions.
• Debt via repurchase agreements.
• Interest rate swaps.

 

The asset side consists of

• Gilts.
• Interest rate swaps.
• Cash equivalents.

 

As of 1 September 2022, LDIs were showing £300 billion in assets. This was three weeks before the LDI crisis.

What caused the LDI crisis?

In 2022, the chancellor, Kwasi Karteng, set out his budget for growth. During the budget, he reversed a decision to increase corporation tax. Furthermore, he also introduced other tax cuts. These were to stimulate growth in the UK economy. However, there were very few details of how these cuts would be funded.

As a result, the bond market became extremely nervous. This sent gilt yields spiralling and the value of the pound falling markedly. Government bond prices were falling days after the announcement. This, in turn, triggered margin calls on liability-driven investment (LDI) strategies that used leverage. Furthermore, some defined benefit pension schemes required employers to provide emergency funding.

The gilt market movements were severe. As such, the pension regulator appealed to the Bank of England to intervene. On 28 September 2022, the bank started buying Government bonds. The aim was to stabilize prices. The bank purchased £14 billion worth of gilts.

Many companies also made additional funding to their pension schemes. This was to help them through the market turmoil. The pension protection fund was also affected. They used an additional £1.6 billion cash for additional security linked to its LDI program. This is according to the Financial Times publication from 2022.

A change for defined benefit pension schemes

According to experts, DB schemes are in a much stronger position than they were during the mini-budget crisis. The Bank of England raised interest rates thirteen times during 2022 and 2023. This certainly aided the recovery.

ISIO chief investment officer Barry Jones explains. “Schemes are holding more gilts and high-quality credit, while reducing leverage in their liability-driven investment portfolios.” He goes on to say. “The new Funding Code will only accelerate this shift towards greater stability. Furthermore, the conversation has moved on from how to get to full funding to a conversation of surplus sharing between sponsor and members and running on."

The PPF’s 7800 index shows a significant improvement in private-sector DB pension funding levels. This has taken place over the last five years.

The UK's formal exit from the European Union was in late 2019. At that time, the PPF 7800 index showed an overall funding level of 99.4%. This was with £1.7trn of assets held against almost the exact value of liabilities.

However, due to COVID-19 and national lockdowns, funding fell to 92% in June. It then began recovering. This was in line with the UK's economic recovery. By the end of 2021, the funding level was 107.7%.

When Rishi Sunak became prime minister in October 2022, the PPF's funding level had spiked to 137.6%.

Since then, liabilities have fallen below £1 trillion. Assets are also heading in the same direction. Furthermore, since January 2024, the overall funding level has mostly ranged between 123% and 129%.

Avoiding a repeat of the liquidity crunch

The pension regulator has introduced more guidance over the last three years. This will help trustees better manage LDI strategies and hedging programs. Furthermore, they have also introduced a new Funding Code.

“Schemes now run with much larger buffers… The question is whether these safeguards are more than just a comfort blanket.” Barry Jones, ISIO.

In January, the Bank of England launched the Contingent Non-Bank Financial Institution Repo Facility. This will support pension funds and LDI managers during times of market stress. However, the bank has said that the facility will only be activated during episodes of severe gilt market dysfunction.

According to a Bank of England report from last year. The "financial and operational resilience" of LDI funds and strategies had improved since 2022.

It states that there has been a significant reduction in leverage. Also, many LDI clients have set up "waterfall" arrangements. These arrangements give LDI managers access to liquid assets if further collateral is needed. There is no question that LDI looks different today than it did in 2022. Schemes now run with larger buffers. As such, it helps avoid the kind of forced gilt sales that took place in 2022.

If there is any future volatility, managers will be able to rely more on buffers. This is rather than raising extra collateral.

Although the system appears to be safer, only time will tell. The real test will be how these safeguards work in the event of another LDI crisis. To avoid history repeating itself, we need a clear knowledge of when and how buffers can be used.

Will tensions rise again?

The UK is certainly not alone in facing fiscal challenges. Rising bond yields represent a vicious circle for the Government. The increase means that the cost of servicing existing debt also rises. In the 2025/26 fiscal year, the Government forecasts spending £110 billion on debt interest.

However, it is different to 2022, and confidence is not entirely lost. Furthermore, the risk of a similar response in the bond market to 2022 remains low.

Summary of the LDI crisis

So, three years on from the LDI crisis, has the UK pension industry learned its lesson? Indeed, changes are in place to avoid a repeat of the LDI crisis. Both the Bank of England and the pension regulator have taken steps which will help prevent a repeat. Also, provisions are in place to help in a market crisis. These include buffers, assisting managers with extra funding rather than raising extra collateral.

If the Government can bring debt levels down or reduce borrowing costs, this should have a positive effect on markets.

Only time will tell if the pension industry has learned its lesson. If you need any financial advice. Let regulated advice help you.