Gilt yields drop while schemes plan for life after miniBudget U-turn

Pension schemes are reviewing their asset allocations and resilience to future market shocks, as gilt yields fell in response to the abandonment of most measures presented in the September “mini” Budget.

On October 17, new chancellor of the exchequer Jeremy Hunt reversed almost all of the tax cuts planned by his predecessor, Kwasi Kwarteng. Kwarteng’s Budget announcement in September was followed by a spike in gilt yields that triggered a liquidity crisis for defined benefit pension schemes.

The turmoil prompted the intervention of the Bank of England, whose gilt-purchasing programme — initiated in a bid to stabilise prices — concluded on October 14.

During this period of intense market volatility, schemes’ use of liability-driven investments has come under intense scrutiny.

It remains to be seen the extent to which clients will want to inject additional monies into LDI funds given how poorly they have performed over 2022

Rob Dales, Atkin Trustees

Speaking on October 15, BoE governor Andrew Bailey said that “violent moves” in the gilt markets have “put the spotlight on flaws in the strategy and structure of one important part of a lot of pension funds”.

The spike in gilt yields prompted collateral calls from LDI managers, which forced schemes to sell assets including gilts, multi-asset credit and even equities in the search for liquidity.

“There haven’t been any new collateral calls but some hanging over from last week are still being processed,” Zedra managing director Richard Butcher told Pensions Expert. “I think most firms and schemes were waiting to see what happened [on October 17].

Collateral calls will have eased

Yields on 30-year UK gilts fell markedly in response to Hunt’s announcement, dropping 0.5 per cent to 4.32 per cent. This will increase pension liabilities.

“The apparent pause in the steady upward drift of gilt yields will be welcomed, especially by those who still have some risk of collateral calls,” former pensions minister and LCP partner Sir Steve Webb told Pensions Expert.

“However I don’t think schemes want to see sharp falls as they are (ironically) now less hedged in many cases.”

Capital Cranfield professional trustee Mark Hedges told Pensions Expert that collateral calls will have likely eased given the movement of gilt markets. He added that some calls may still be made due to continued deleverage activity by asset managers that are reducing the leverage on their funds.

“It is likely [trustees] will seek to maintain bigger margins of cover in the future to protect against similar shocks,” Hedges said.

“There is likely to be some planned asset realisations to help facilitate the building of these larger buffers. Whereas funds may have maintained collateral to support a shock of 150-200 basis points prior to this crisis, they may now seek to cover against circa 350bp-400bp of rate rise.”

One pensions consultant, who did not wish to be named, is guarded against excess optimism following Hunt’s announcement.

“We’re loath to be too optimistic as some of the volatility in the market may well remain as pension schemes assess and rebalance their positions, but we’re pleased and slightly relieved,” they said.

‘Clients will have to inject further collateral into LDI funds’

The liquidity crisis had different effects for schemes, depending on their size. Small schemes that have LDI exposure use pooled funds, which often have weekly dealing days, making it impossible in some cases to respond quickly to market movements.

These schemes do, however, have the advantage of collateral assets being in pooled funds, leaving them typically shielded from the liquidity issues faced by other schemes. The use of investment platforms enabled smaller schemes to respond with speed to collateral calls.

 “Many small schemes do not have a fully developed journey plan,” Atkin Trustees director Rob Dales told Pensions Expert.

“Those without LDI exposure should be looking at taking advantage of current yields, and where it is affordable transferring a proportion of growth assets to gilts.”

“Some schemes may see the gap to full buyout to be affordable now (or even removed), but they should not be rushing to secure insurance company policies at a time when there is no competition in the pricing for small schemes.”

Dales predicted that the sponsors of schemes with improved funding positions would look to renegotiate recovery plan contributions, with the aim of paying less in order to deal with increased borrowing and energy costs and maintain their covenant.

Legal & General Investment Management and Columbia Threadneedle Investments have indicated that they are in the process of reducing leverage for their range of LDI funds, he said.

For “standard” LDI funds, the LDI managers have historically targeted a duration of around 60 years, which results in leverage of around three times, Dale observed. Following the volatility in the gilt market, they are reducing their target durations to around 45 years, equivalent to leverage of around 2.5 times.

“What this means is that clients will have to inject further collateral into the LDI funds (on top of what they have already been asked for due to the rise in gilt yields, which increased leverage) if they want to maintain the levels of hedging that they had previously been targeting,” he continued.

“In round numbers, reducing leverage from three times to 2.5 times requires 20 per cent additional investment into LDI. If clients do not inject this extra money into the LDI funds, then their hedge ratios will fall by around 20 per cent.

“I think it remains to be seen the extent to which clients will want to inject additional monies into LDI funds given how poorly they have performed over 2022.”

It is understood that the majority of trustees and advisers that Columbia Threadneedle has spoken to over the past couple of weeks wish to retain hedging wherever possible. Clients that are reducing hedge ratios are generally doing so because they are unable, rather than unwilling, to inject additional capital.

Pensions Expert has approached LGIM for comment. Columbia Threadneedle declined to comment.

Pension tax relief is maintained

The decision to abandon cutting the basic level of income tax from 20p to 19p also has consequences for pension tax relief.

Currently, for every £100 contributed to a pension, most savers receive an additional £25 in their pensions through tax relief. Lowering the income tax threshold would have also reduced the tax relief available to savers.

“Scrapping the reduction of the basic rate of tax will retain the simplicity of pensions taxation and tax relief,” PensionBee chief executive Romi Savova said.

“However, for many, including pensioners, it will be disappointing to see a core measure, designed to support savers during the cost of living crisis, has been pulled back.”

Defined benefit pension schemes were not on the verge of collapse before the Bank of England’s gilt market intervention, the Pensions Regulator’s chief executive Charles Counsell has said. Read more

Cushon director of policy and research Steve Watson called on the government to simplify pension tax relief to help savers understand the value of saving for retirement.

“With average pension contributions hovering around the auto-enrolment minimums, it is clear that the overly complex system is not doing its job to incentivise pension saving,” he said.

“Making everyone aware that they can keep more of their hard-earned money for themselves will encourage more people to increase contributions and save for a secure future.”