Schemes using a fiduciary manager (FM) or outsourced Chief Investment Officer (OCIO) to manage their total assets, including their liability driven investments (LDI) strategies, were amongst those best able to act with the urgency required during the 2022 liquidity crisis. Why? Because of strong governance arrangements, transparency and the integrated nature of their entire investment portfolio and operational efficiency.
The 2022 liquidity crisis that affected many UK pension schemes started with falls in the value of gilts at unprecedented speed and scale following the UK Government’s “mini-budget”. This fall in gilts prices created a self-perpetuating cycle. Liquidity and operational constraints prevented some pension schemes from raising collateral at the speed and scale required, forcing them to reduce their LDI exposure. The associated sale of gilts drove down gilt prices even further.
The challenging combination of forced reductions in liability hedging as gilt prices fell together with the subsequent “snapback” in gilt prices before pension schemes could restore hedges was a key risk faced by some schemes during this period of market stress.
The pension schemes who could meet the collateral demands of their LDI programme’s bank counterparties or settle repo contracts expiring during the market turmoil were well positioned to maintain their liability hedges. As discussed further below, some pension schemes were less able to transact and transfer the scale of assets needed to meet collateral demands in time even if they had enough assets to meet their collateral calls. Schemes using a fiduciary manager (FM), or outsourced Chief Investment Officer (OCIO) to manage their total assets were, in our experience, amongst those best able to act with the urgency required. Why? Because of strong governance, transparency and the integrated nature of their entire investment portfolio and operational efficiency.
How can a pension scheme’s operational arrangements act as a constraint?
Broadly, there are two parts to collateral management for LDI strategies. First, LDI investors hold a pool of assets, such as cash or gilts, available to post on demand to meet the collateral calls of bank counterparties (the “collateral pool”). Often the assets are held in custody and readily available to transfer between the scheme and associated counterparty allowing the daily collateralisation process to run smoothly.
The second part is the “top up” of the collateral pool from time to time. If gilt prices fall sufficiently, the collateral pool may need to be topped up by sales of other scheme assets. This helps ensure there are sufficient assets available on demand to meet further collateral calls. In principle, a pension scheme can sell any assets to “top-up” their collateral pool within a reasonable timeframe, except for long-term illiquid assets, such as real estate and private equity. However, even for the most “liquid” assets, operational constraints might mean it can take several days from identifying the need to top-up, to the settlement of cash in the collateral pool.
Diversified sources of liquidity can increase resilience in stressed markets
Pension schemes with a diverse range of liquid assets fared better in the crisis because, barring any operational constraints, they could look across a greater proportion of their portfolio to realise assets. They were able, for example, to use US credit assets for liquidity because this market was largely unaffected by the turmoil in the gilts market.
Liquidity and efficient operational arrangements go together: it is imprudent to rely on a liquid asset being available to top up collateral if held in a governance structure with inherent delays because of the need for trustee approvals, notice periods, infrequent dealing dates and long settlement periods.
How can fiduciary management and OCIO improve liquidity management?
- Enhancing the efficiency of pension schemes’ governance processes. Trustees can delegate authority to instruct trades and meet day-to-day liquidity needs to an FM or OCIO. This might include meeting collateral calls, topping up collateral pools, transitioning assets between managers and meeting schemes’ ongoing cash flow requirements.
- Managing both the collateral pool and top up assets under one roof. Pension schemes who held LDI programmes and “top-up” assets with the same manager were, in our experience, more easily able to top-up their collateral quickly because the “plumbing” enabling rapid topping-up was already in place. Trustees should expect FMs or OCIO‘s with in-house LDI capability to have better visibility, transparency and operational efficiency than those using external LDI managers.
- Complete transparency. By having full sight of scheme assets and responsibility for the entire portfolio, FMs and OCIOs can provide timely scheme-specific information on funding, portfolio positioning, hedging levels and collateral adequacy. This can enable trustees to remain fully appraised and keep all their stakeholders informed throughout a crisis period.
- Regular collateral and liquidity stress testing. An FM or OCIO can assess a scheme’s liquidity profile and stress test for different market conditions. If a stress test fails, then different levers can be available for action, such as topping up the collateral pool from other assets or reducing exposure to LDI or other derivatives. The most appropriate choice of lever should allow for individual scheme circumstances, including the strength of the sponsor covenant.
- Access to a diversified pool of assets and managers. Having a choice of assets to top up the collateral pool makes a pension scheme’s overall investment strategy more robust. This is because, whilst liquidity can quickly deteriorate in one asset class or geography, there may be other assets that remain unaffected.
If managed inappropriately, liquidity constraints may cause pension schemes to suffer higher costs and forced divestments, as well as increasing the risk for their trustees having to make short-term decisions. Good liquidity management remains a crucial part of pension scheme governance and investment management. In our view, delegating some or all investment decisions to an FM or OCIO can significantly improve a pension scheme’s liquidity management arrangements.
