The UK’s largest private-sector pension scheme increased its exposure to debt-fuelled investment strategies earlier this year in spite of warnings the move would bring “significant risks”, according to reports today adding to concerns that another financial crisis could be brewing beneath the surface.
Concerns about liability driven investment strategies (LDIs) have hit the headlines after they were at the centre of the market chaos last week following the mini-budget which almost collapsed a number of defined benefit pension schemes.
Reports today suggest the £90bn Universities Superannuation Scheme (USS) put more of its members’ assets into LDIs despite opposition and warnings from several leading universities.
The turmoil wreaked by LDIs, which are derivatives meant to help insulate pension funds from the impact of inflation, was only brought under control by a large intervention from the Bank of England.
Reports suggested that USS chief executive Bill Galvin, who previously headed up the Pensions Regulator, pushed for increased use of LDIs in the pension’s portfolio and for them to be a cornerstone of its investment strategy.
But in a letter addressed to Galvin in February, representatives from Cambridge, Oxford and Imperial College wrote: “We believe the increase in leverage may introduce potentially significant risks into the scheme in a period of high market volatility.”
A warning that proved highly accurate.
The USS is understood to have proposed to increase its LDI exposure from 35% to 52% of its portfolio, with leverage more than doubling from 17% to 37% of weighted assets, according to a consultation letter sent in February.
The Bank of England confirmed today that without its intervention a large number of pooled LDI funds would have been left with negative net asset values and would have faced shortfalls in the collateral posted to banking counterparties.
[Defined benefit] pension fund investments in those pooled LDI funds would be worth zero, it said.
As a result, it was likely that these funds would have to begin the process of winding up which would have led to a large quantity of gilts being sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability, the Bank said.
The risks of LDIs were highlighted as early as 2018 by the Bank of England which said they were an area of concern.
On page 54 of its November 2018 Financial Stability Report it argued that it is "not clear" whether pension funds and insurers pay sufficient attention to the liquidity risks involved in using LDI programmes intended to improve the returns from gilts.
Of course the risks of leveraged financial instruments is nothing new, the cycle goes full circle as investors and regulators gradually forget, forgive or ignore the lessons of past crises and attitudes to risk change.
Memories of LTCM spring to mind - brought to its knees by the devaluation of the Russian rouble which sent US markets into freefall.
As a result, LTCM's highly leveraged investments crumbled and by the end of August 1998, it had lost 50% of the value of its capital investments, pushing a number of banks and pension funds that had invested in LTCM close to bankruptcy.
One example of many and perhaps LDIs will not join this list and a full-blown crisis has now been averted.
But at the very least, a run on the markets sparked by another liquidity driven financial instrument should concentrate the minds of investors, regulators and central banks alike.