Royal Mail, the letters and parcels group owned by International Distributions Services PLC (LSE:IDS), is reported to have rushed forward the monthly payment into its pension scheme to help prevent a cash crunch after the government's hapless 'mini budget' last month.
After chancellor Kwasi Kwarteng's fiscal statement sent money markets tanking it sparked pandemonium in a little-known – but still significant at £1.5trn – corner of the financial markets, LDIs, or liability-driven investment strategies.
LDIs are an investment strategy based on the cash flows needed to fund future liabilities, a derivative that some pension funds used to insulate themselves from the impact of inflation.
In the turmoil following the budget, Royal Mail responded to a request from the trustees of the Royal Mail Pension Plan to provide emergency liquidity, the Telegraph reported overnight, as the trustees and others across the City feared a run on pension funds driven by LDIs would leave major funds insolvent.
With the Royal Mail pension scheme covering 124,000 members and with liabilities of around £11bn, the company made an early monthly payment to help prevent a cash crunch.
After the Bank of England stepped in last Wednesday to calm bond markets in the wake of the meltdown following the budget, deputy governor Sir Jon Cunliffe said pension funds need to learn the lessons and change their ways.
Writing to parliament’s Treasury Committee, Cunliffe revealed how serious the situation became, as the plunge in the value of UK government debt after the mini-budget threatened financial stability.
Cunliffe explained that the major invention was triggered by warnings that pension fund LDIs were under massive pressure.
“LDI strategies enable DB [defined benefit] pension funds to use leverage (i.e. to borrow) to increase their exposure to long-term gilts, while also holding riskier and higher-yielding assets such as equities in order to boost their returns,” Cunliffe commented.
As the drop in bond prices was putting increasing pressure on LDI schemes, it forced pensions to put up more collateral which they raised by selling gilts or in the case of Royal Mail's, calling for extra funds.
The BoE received market intelligence of increasing severity from a range of market participants, and in particular from LDI fund managers, Cunliffe said.
On Tuesday 27 September he said the Bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value.
“As a result, it was likely that these funds would have to begin the process of winding up the following morning,” he said, which could have led to a "self-reinforcing spiral" as collateral by banks that had lent to these LDI funds was likely to be sold on the market, leading to widespread financial instability.
Cunliffe said regulators are closely monitoring LDI funds as they put their positions on a sustainable footing and prepare better for future stresses.
“While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured,” he said.
In response to the volatility, the Pensions Regulator reaffirmed that trustees and advisors should monitor the resilience of their investments, risk management practices and funding arrangements.
But law firm RPC said pension fund trustees conducting LDIs could face legal action.
Rachael Healey, a partner at RPC, said: “Trustees of pension funds that had to unwind positions and suffered losses or did not react appropriately to instability in the gilt market, could find themselves in the line of fire.”
“Trustees are ultimately responsible for the scheme’s investment decisions. If they fail to review the investment position of a scheme or revisit their deficit reduction plans, then they could find themselves facing legal action,” she commented.
RPC says actuaries also need to be aware of the risks that LDI strategies can pose.
Healey added that “trustees and actuaries need to ensure they are well-placed to react to market volatility. While not all market moves are foreseeable, trustees and actuaries should have plans in place to react appropriately to market falls and implement solid risk management practices to limit losses in pension value.”