Aaron Punwani says the key question is what is the right level of leverage going forward.

The time limited intervention by the Bank of England (BoE) restored orderly functioning to the gilt market last week, but even in the short term, who can confidently predict what’s going to happen on 14 October when the bank has signalled it will withdraw its support?

Many trustees may be wondering what happens when the BoE steps back but it is worth remembering that the Bank didn't actually buy many gilts at the end of September - it was the signalling of support that made all the difference.

As such, market reaction may depend not only on what they do, but what they say. We are advising schemes to be prepared for more volatility and take what actions they sensibly can in the coming days.

Taking perspective

As I write this, one thing that's crystal clear is that all participants in our industry need to continue working together for clients in the wake of a significant market event last week. I've been so proud of the dedication shown by my colleagues as well as others around the industry at other consulting firms and asset managers. We all need to keep delivering for our clients and putting them first.

As well as looking ahead, we also need to think about what lessons need to be learned and having had time to reflect it's clear to me that the industry needs to approach this moment with humility and openness, recognising that the world may have changed compared to the environment in which we have operated for much of the last decade. In the meantime, here are my reflections on what happened last week and the implications going forward.

What happened last week

You will of course have already read much about the events of last week, so I shall keep this brief. The market movements in gilts we saw were larger and faster than anything we had seen before. This put immense operational stress on the system and created a disorderly market in gilts. An important behavioural insight is that the driver and timing of specific shocks is incredibly hard to predict - for example, previous severe shocks such as the global financial crisis, Brexit, the pandemic and the Ukraine war posed less challenges to gilt markets than the events following September's mini-budget.

The movements were larger than what some liability-driven investment (LDI) programs had been designed for. The BoE's intervention was important to restore orderly functioning and give pension funds breathing space to reassess their strategies.

To put these events into proper context, it's vital to understand the aim, and some of the history, of LDI.

Why do pension funds use LDI?

LDI is a risk management tool, it helps trustees and sponsors manage volatile deficits. It began in the early 2000's and since grew to £1.5trn. LDI worked well through other periods of considerable market stress such as the 2008 crisis, the period of quantitative easing and Covid. LDI has worked to smooth funding positions and stop wide deficits from emerging unexpectedly. Clients have been glad they had it in place - trustees because it has enhanced the security of members' benefits, and sponsors because it has made the pension fund lighter on their balance sheet with more predictable costs.

Coming into September, most defined benefit (DB) pensions funds stood in a good (or very good) overall position, the best funding position for decades. Most remain so even after last week's seismic shifts, although winners and losers are an inevitable by-product of such turbulence.

But LDI uses derivatives, and derivates need collateral. LDI's use of derivatives is intended not to speculate on markets, but for risk management, to hedge interest rates and inflation. Derivatives are collateral-hungry when there are market shocks. And it is the extent of reliance on such derivatives that will need to change for some schemes going forward.

What does this mean for LDI now

The foundations of LDI remain sound, but key questions arise around design practicalities. LDI programs had been designed to cope with higher rates; the key issue was the size and speed of the moves we saw. The key question in the aftermath of last week is what is the right level of leverage going forward - in other words how big a rate change they should cater for over a matter of days.

We expect to see continuing demand from trustees to manage risk through LDI, especially given strong funding positions. Journey plans for DB pension funds need LDI, without it it's like trying to hit a moving target, and if you are close to a buyout, hedged liabilities are the currency of the transaction.

But where LDI at higher gearing levels has been incorporated with scheme asset allocations, the level of leverage will need to reduce going forward. Asset managers have already insisted on that following last week's learnings - fearful that we are not out of the woods and large sudden shifts may be repeated.

This reduction in LDI leverage has considerable knock-on implications. Trustees and sponsors of schemes with leverage and liquidity constraints will have to reckon with a different trade-off between risk management and returns. Some may have to opt for less hedging, or lower returns. Where schemes are investing in growth assets, liquidity is likely to now be key. This could reduce the appetite of the £1.5trn private sector DB universe to make illiquid investments, in a reversal of the trend of the last decade.

Concluding thoughts

LDI is systemically important and needs to be seen as such. Let's evolve it to make it work for the next 10 years.

And returning to the theme of humility, last week's events are a salutary reminder that risk models and a probabilistic view of the world can only take you so far. Stress testing against specific geopolitical or macroeconomic scenarios become an increasingly valuable tool as the world becomes ever more unpredictable.

This blog was first published in Professional Pensions on 6th October.