The liability-driven investment (LDI) crisis in late 2022 sent shockwaves through the UK pensions industry.
It caused sharp price falls in the financial markets driven by fears that the government would be unable to fund its Growth Plan 2022. A sharp increase in gilt yields resulted, which in turn led to a fire-sale of assets and resulted in an unprecedented liquidity squeeze. It was one of the most volatile weeks in the UK bond market and left many consultants, trustees and LDI providers reeling.
Taking the time to properly understand LDI, being prudent in our assumptions, and being as diversified as possible, ultimately paid off for our clients.
DWA however navigated the LDI crisis well and as a result our clients were able to weather the LDI storm better than others. Our strategy was to ensure that we did not hold UK Corporates and gilts as a source of collateral, instead we chose to be more prudent and to either use only cash. In addition, the Growth assets that we held were held in diversified funds, and not particularly exposed to the UK market.
We were able to mitigate the risks the market presented by:
- Investing Growth Assets in Globally diversified portfolios with only a market weight in the UK. The majority of growth assets were daily dealt and very liquid, reducing any liquidity squeeze risk
- Tempering LDI leverage with the use of a cash buffer. Cash provides a ready source of liquidity, and is not correlated with other risk assets such as gilts
- Conducting rigorous due diligence on the LDI providers recommended and we therefore avoided providers where problems were encountered
- Under hedging (around 50% – 90%) of liabilities unless a scheme was fully funded on a buyout basis
Our approach ensured we were able to avoid the challenges that other consultants faced, and, as our client’s funding positions improved they were able to meet their liquidity obligations.
Preparing for market shocks
Well ahead of the LDI crisis our consultants recognised the danger that rising interest rates presented. This knowledge ensured that we focused our LDI strategy on ensuring that we would be able to manage this. We deliberately under hedged to ensure that if rates did rise, which we believed would be the case, the increase in funding levels (as liabilities would have fallen by more) would be more than offset by reduced expected return caused by the reduced allocation to Growth assets.
We set out to ensure that our clients had the ability to meet collateral calls quickly should the need arise. And hindsight has shown that our prudent strategy was the right one.
How DWA’s approach differed from other LDI strategies?
The challenge that other consultants faced is that many schemes were 100% hedged and had invested in UK bonds as collateral. In addition, many schemes did not invest sufficiently in globally diversified growth strategies. This would prove to be a challenge for these schemes. Whereas our decision to use cash, given we were not happy with the 3 x leveraged approach, helped our clients to avoid a cash squeeze because there was a buffer in place to reduce leverage.
What also sets our approach apart is that we always understand our client’s governance structure, so that we can navigate our client’s return objective and risk tolerance efficiently. We always determine how well the scheme is governed, and how it works, and ensure our solutions match the structure. This knowledge gave us the ability to make decisions efficiently at a time where speed was critical.
What we learnt from this unprecedented experience
We believe that we were able to navigate the market by being prepared. We had considered the risk implications of possible events and ensured that we had designed a strategy to mitigate them.
We stuck by our guns, took some tough decisions, which while appearing to be out of sync with others in the industry, ultimately ensured our client’s were buffered from the market shocks.
By taking the time to properly understand LDI our strategy of being prudent in our assumptions, strategy and models, and of being as diversified as possible, ultimately paid off for our clients.