UK bond turmoil leaves smaller pension schemes with longer-term costs

By Carolyn Cohn

LONDON (Reuters) – The recent crisis in Britain’s government bond market means smaller UK pension schemes may fork out more money for a bespoke liability-driven investment (LDI) strategy in future to ensure better protection, industry sources say.

LDI products, sold by asset managers such as BlackRock, Legal & General and Schroders to pension funds, use derivatives to help them “match” assets and liabilities so there is no risk of shortfall in money to pay pensioners.

Pension funds, who must post cash as collateral against their LDI derivatives in case they turn sour, were caught out in late September by a sharp rise in UK bond yields after the market took fright at government plans to fund tax cuts by borrowing.

As pension funds scrambled for cash to meet margin calls, the Bank of England intervened to stabilise the market and avoid the collapse of some LDI-exposed funds.

Smaller private sector pension schemes exposed to LDI – those looking to hedge up to 400 million-500 million pounds ($452 million-$565 million) of overall assets, have typically held assets together with other schemes in pooled LDI funds, while larger schemes have their own funds, or segregated mandates.

Industry analysts say some smaller schemes may now consider switching to tailor-made LDI products as that could protect them more effectively from another market rout. But the higher cost will reduce their scope to invest in the higher-returning assets that boost funding positions, they add.

LDI hedging costs through a personalised arrangement for a small pension fund would currently cost around 50% more than through a pooled fund, according to one consultant who declined to be named.

RIGID DEMANDS

LDI funds have become popular as years of low interest rates put some corporate defined benefit pension schemes, which provide retirement income for millions of people, into deficit.

Out of more than 5,000 defined benefit, or final salary pension schemes in Britain, around 3,000 use LDI, and around 1,800 of those use pooled funds, according to The Pensions Regulator.

Pooled funds are more rigid in demands for cash than bespoke funds, making it tougher for pension schemes using such funds to meet recent margin calls, industry sources say.

“There were significant advantages of having segregated accounts versus pooled funds,” said Steve Hodder, partner at LCP, of the recent rout in UK bonds, also known as gilts.

Pooled funds are cheaper because managers were able to pool fund set-up and documentation costs, but segregated funds meet the needs of individual schemes more closely, he added.

“I wouldn’t be surprised if over the months ahead we advise some schemes to make this switch.”

Pub operator Mitchells & Butlers uses a segregated mandate for its 2 billion pound pension scheme and its chair of trustees Jonathan Duck told Reuters the scheme did not have a problem in the recent gilt turmoil as it had “shedloads of liquidity”.

But pension schemes that could not meet margin calls in time – many of them smaller schemes – had their positions liquidated by LDI fund managers. This meant they were no longer hedged against sharp moves in bond yields.

The recent drop back in yields has worsened their funding positions as lower interest payments mean they need to set aside more money now to pay future pensions.

Edi Truell, CEO of pensions consolidator The Pension SuperFund, said a drop in long-term yields of one percentage point could equate to “about a 10% loss” in a scheme’s funding position.

Larger schemes in segregated funds were more likely to have retained their hedges, industry sources said.

REGULATORY SCRUTINY

Many pensions still want hedges, even though the positions are becoming more expensive as LDI funds reduce leverage, or borrowing, amid the prospect of more regulatory scrutiny.

A Bfinance survey of 21 UK investors in October showed all of them planned to maintain their existing LDI strategies.

However, the higher fees of a segregated fund may be beyond many schemes, consultants say.

Large schemes in segregated funds pay lower fees for more volume – a benefit small schemes cannot enjoy.

For example, a major LDI manager charges 4 basis points – or 0.04% – in management fees for a lower-risk “passive” mandate for schemes’ first one billion pounds in assets and 3 bps for the next billion, one consultant said.

An alternative is a so-called “bespoke pooled fund”.

This puts schemes in a “fund of one”, using generalised documents which make it cheaper than a segregated fund, though more expensive than a regular pooled fund, consultants said.

LDI fund managers BlackRock and Insight Investment did not respond to requests for comment. Legal & General Investment Management and Schroders declined to comment.

Some pensions, however, are balking at the cost and considering lowering their LDI exposure, particularly as yields remain higher than they were a year ago, which reduces the risk of staying unhedged.

With LDI funds expected to offer lower leverage in future, pensions will also have to tie up more of their investments in lower-yielding assets such as gilts to match their liabilities.

“All of that makes LDI less attractive than it was before,” said Andrew Overend, partner at consultants First Actuarial.

($1 = 0.8852 pounds)

(Additional reporting by Tommy Reggiori Wilkes; Editing by Susan Fenton)