Beyond the waterfall: Embrace flexibility in collateral management

For pension schemes, the recent rise in gilt yields poses significant challenges for meeting collateral obligations, which in turn has sharply increased the need for effective liability-driven investment (LDI) strategies and collateral management frameworks.  As a result, pension schemes are reassessing their strategies, bringing the traditional concept of the LDI collateral waterfall to the forefront. 

When I hear pension professionals talk about waterfalls, my mind instantly returns to my home country of Zimbabwe and one of its most impressive spectacles, Victoria Falls. The powerful and mesmerizing flow of water provides a fitting metaphor for the structured process of a collateral waterfall, which involves a predefined order in which funds are sold to meet collateral obligations. Trustees determine that order with guidance from their investment consultants. Like a waterfall, the initially specified fund—typically an equity fund—is the first to be depleted, followed by the second and third choices if more collateral is required. This structured approach ensures that the pension scheme can meet its obligations efficiently.

Limitations of the waterfall

Like braving the Zambezi River rapids below Victoria Falls on a raft, managing a collateral waterfall is no easy task. There is really no turning back or stopping once you've embarked on the journey. You basically have to execute and hope for the best. As gilt yields rise, liabilities change in value, necessitating frequent portfolio rebalancing to mitigate risk and stay afloat.

While the waterfall approach is helpful, its design reflects certain constraints inherent in the traditional tools available to trustees and their advisers. And like rapids in a river, these challenges can create turbulence and elevate risk:

• Limited visibility: Investment consultants or fiduciary managers may lack daily visibility of asset values that can be used to meet collateral payments.
• Operational limitations: Operational constraint may hinder rapid execution during market volatility.
• Execution constraints: The LDI manager or platform provider may have certain constraints, also hindering execution.

Charting a more flexible course

Overcoming challenges posed by traditional methods of collateral managements requires agility, readiness, and the ability to adapt, much like navigating a complex river. At SEI, our dynamic cash flow management framework is more flexible. Instead of relying on a static, pre-agreed hierarchy of funds to sell, we actively monitor performance and market conditions and assess the appropriate source to meet collateral payments. These could be from a single fund or a diversified mix of asset classes within the liquid elements of the growth portfolio, and could range from liquid alternatives to managed volatility equities.

A key advantage of this approach is that it allows, in short, better management of investment risks. 

Historically, equities and bonds have often moved in opposite directions, making equities a good go-to asset class for collateral calls. However, this is not always the case, especially over shorter time periods. Recent market examples to the contrary include:

• 2022 inflation shock: Rising inflation and aggressive central bank rate hikes led to simultaneous declines in bond and equity markets, challenging the conventional diversification framework.
• December 2024: We saw gilt yields rising with equity markets also experiencing simultaneous selloffs.

Such scenarios underscore the importance of having a flexible and proactive liquidity and collateral management strategy. Our approach enables us to:

• Prioritise the sale of funds that are performing relatively well (“banking the gains”).
• Minimise transaction costs and avoid the crystallisation of market losses by refraining from selling underperforming or stressed assets.
• Achieve manager diversification. The collateral assets remain managed by the best-in-class manager for each specific asset class, who may not necessarily be your LDI manager. This may also reduce any risk around potential conflicts of interest arising from giving the LDI manager control over collateral assets.
• Take a holistic approach by accounting for each scheme’s specific liquidity considerations, including benefit payments and contributions.

On a related note, this proactive approach is not limited to meeting LDI collateral calls during periods of market stress. It is also our business-as-usual approach to meeting monthly member benefits as efficiently as possible.  

Integrating technology and expertise

Management of cash flow needs for increasingly mature pension schemes requires more than just an outdated adherence to a traditional waterfall structure. Instead, it calls for an approach that leverages technology, real-time data, and deep market expertise. Our platform provides these advantages to schemes of all sizes, giving trustees the best chance of navigating turbulent waters with confidence.

If you would like to learn more about our approach and receive a complimentary health check for your pension scheme, please contact the team below. 

Important information

This is a Marketing Communication. This webpage contains marketing material about our fiduciary management service. This webpage does not represent impartial advice on this service. In certain cases, you are required to conduct a competitive tender process prior to appointing a fiduciary manager. Guidance on running a tender process is available from the Pensions Regulator.

This webpage is provided by SEI Investments (Europe) Ltd ("SIEL"). SIEL is authorised and regulated by the Financial Conduct Authority. Financial Services Register Firm Reference Number (FRN) 191713. Registered office; 1st Floor, Alphabeta, 14-18 Finsbury Square, London EC2A 1BR. Registered in England and Wales – company number 03765319. This webpage is only for the intended recipient and should not be distributed further. While considerable care has been taken to ensure the information contained within this webpage is accurate and up-to date and complies with relevant legislation and regulations, no warranty is given and no representation is made as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information. The views and opinions in this webpage are of SEI only and are subject to change. They should not be construed as investment advice.