MPs announce rapid investigation into ‘LDPs’ at heart of bond crisis

The influential Work and Pensions Committee has published a call for evidence into so-called ‘liability driven investments’ (LDIs). These investments are popular with defined benefit (DB) pension schemes and were at the heart of the bond market crisis that hit the UK recently.

You can see detail of the call for evidence here.

Pensions found themselves caught in the crossfire of the recent crisis that eventually led to a dramatic £65 billion intervention from the Bank of England.

The turmoil centred on investments commonly held by defined benefit (DB) schemes that risked exacerbating the UK bond sell-off caused by Liz Truss and Kwasi Kwarteng’s disastrous mini-budget.

While clearly there was a significant cashflow issue facing these LDI strategies, reports of pension funds facing ‘insolvency’ were at best hyperbole and at worst downright scaremongering.

As the Committee digs into what went wrong with LDI funds, it is important consideration is given to the confusing and potentially damaging headlines millions of savers and retirees saw as a result.

Talk of pensions ‘crisis’ and the risk of pension funds becoming ‘insolvent’ caused lots of people to fear they risked losing their entire retirement pot. This was simply not the case. Even DB scheme members’ pensions would only have been threatened if the sponsoring employer’s solvency was threatened – and nobody was arguing this would happen.

Clearly part of the challenge here is to redouble efforts to boost engagement and understanding around retirement issues. But it is also crucial the Committee reflects on the role of those involved in disseminating complex information to savers, including officials, pundits and journalists.

The central problem with LDI might have been inadequate preparation for a world of rapidly rising gilt yields, but the way those problems were communicated to the wider public caused untold damage to people’s perceptions of pensions.

How pensions were dragged into the mini-budget crisis

DB funds are massive investors in UK government bonds, or gilts, with the income used to pay members’ pensions. Gilts are also hugely influential in valuing liabilities.

LDIs are designed to hedge off the risk associated with gilt yield movements. At a simple level, that means when gilt yields fall and the accounting value of liabilities increases, the investment bank running the hedge will pay the scheme money. Conversely, when gilt yields rise – as we have seen recently – the scheme has to pay the investment bank.

This worked fine during an ultra-low gilt yield environment but became a problem as yields spiked in the wake of the mini-budget – particularly for those LDI funds that had leveraged positions.

As a result, some LDI hedges demanded huge sums of cash, with the risk the gilt sell-off precipitated by the mini-budget would be made even worse by pension funds dumping gilts to post extra collateral.

What we saw was therefore a gilt crisis involving a specific type of investment held by a specific type of pension scheme, rather than a crisis that posed any direct risk to people’s pensions.

It is the strength of the employer that is paramount when determining whether or not a DB pension promise will be paid – and even where this is compromised, the PPF provides a valuable safety net.