Hidden leverage blamed for DB liquidity issues; more data needed

Industry experts have argued that leveraged liability driven investment (LDI), and particularly hidden LDI, were at the root of the recent liquidity issues facing defined benefit (DB) pension schemes, arguing that more data on scheme holdings is needed.

Addressing the Work and Pensions Committee, John Ralfe Consulting independent consultant, John Ralfe, explained that LDI has evolved since its inception, pointing out there is a difference between hedging and leveraged LDI, which is “pure speculation”.

Although Ralfe argued that leveraged LDI is a bad thing, he clarified that it is not necessarily a bad thing in and of itself, acknowledging that some companies are able to use this approach whilst still ensuring transparency in their balance sheet.

Instead, Ralfe argued that hidden leverage has been the key issue in recent months.

"Hidden leverage is undoubtedly a bad thing," he stressed. "Leverage if you are being absolutely clear what you are doing, and that means being clear to the shareholders, clear to the members, clear to The Pensions Regulator (TPR) and anybody else, it may be a bad thing and it may be a good thing, but hidden leverage is always a bad thing."

Adding to this, Agewage executive chair, Henry Tapper suggested that "any leverage in a pension scheme is too much", arguing that "pension schemes should not borrow money, and leverage is in my mind borrowing".

Brighton Rock Group head of research, Dr Keating, agreed that the correct level of leverage in a pension scheme is "zero", pointing out that borrowing is explicitly prohibited under scheme funding rules, and clarifying that while TPR does not consider repo as borrowing, "there is a question of legality there".

In addition to this, Keating raised concerns around the use of derivates in the form of interest rate swaps.

"The problem with these is you receive a fixed rate," he explained, "but you have to pay the short rate, so you are vulnerable to loss if either the price of long-dated gilts goes down, or the cost of short financing goes up, and of course we've seen both of those things this year."

In addition to this, Keating raised questions around the transposition of the European Directive on the use of derivatives, which limits the use of derivatives to investment purposes, or investment risks.

"The UK transposition," he clarified, "omitted the word investment and added a second line, which appears to permit this. No English court to our reckoning would support that transposition, we believe that a court would just rather than put a line through the added sentence, so the use of derivatives to hedge liabilities is also almost certainly illegal."

The panel were more divided when asked whether the regulator could have helped avoid the recent issues, however, as Ralfe suggested that the "idea that the regulator made me do it is a bit silly", while Leeds Business School professor, Iain Clacher, pointed out that the regulator had overseen the shift towards LDI in recent years.

However, the panel agreed that more information on the amount of leverage held by pension schemes is needed, with Ralfe stating that the regulator should be working to gather "much, much more information" on the assets and amount of leverage currently used by the UK's pension schemes.

"I would like to see TPR today requiring all 5,000 pension schemes to provide quite detailed information about their LDI position," he stated.

This was echoed by Clacher, who argued that regulators “definitely should know what pension funds hold and have much more granular detail".

However, Clacher acknowledged that TPR may not be able to do much with this data, also raising "huge concerns" over the upcoming DB funding code, suggesting that "the shorthand for it is LDI on steroids".

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