LDI crisis is a 'stark reminder' on governance, diversification and risk management

The liability-driven investment (LDI) crisis, which followed the September 2022 mini-budget, has given the pensions industry a huge scare. At its heart, the crisis was the result of a rise in gilt yields of unprecedented scale and swiftness. The underlying issue was that too many pension schemes in our industry were exposed to a high degree of leverage within LDI funds or strategies, possibly coupled with insufficient liquidity in assets that ran alongside LDI. High leverage, by definition, meant that schemes could achieve high levels of hedging and simultaneously invest in growth assets to help generate the required returns. However, this came at the cost of potential liquidity risks in the form of asset sales to cover LDI losses and, in extreme, insolvency risks such as default or bankruptcy within LDI funds if they are unable to re-capitalise in time to cover emerging shortfalls.

The LDI crisis, while short, was severe and was exacerbated by the use of high leverage. Over-leveraged positions in LDI strategies caused the liquidity crunch as fire sales were, briefly, an uncomfortable reality for many schemes. Despite a flurry of capital calls, some LDI funds found values falling faster than the funds were able to re-capitalise. The situation was so precarious, in the lead-up to the Bank of England’s intervention to calm the gilt market, that insolvency risks within highly leveraged LDI funds became, for a time, a stark possibility. 

Responding to the crisis

Given how swiftly the market was moving, and the number of decisions that needed to be made, we found it essential to have had robust governance structures in place. For example, an SEI investment oversight working group was able to ramp-up in meeting frequency to match the gravity of the situation, and participants took in a wide range of inputs to assess emerging opportunities and risks to ensure that the right priorities were focused on. These working groups proved to be an advantage in difficult times and all pension schemes may benefit from having an arrangement that mirrors this.

Diversification was also critical to limiting the fallout from the LDI crisis. The age-old wisdom of including a variety of asset classes, currencies, investment styles, geographies, sectors and managers still stands; if anything, these principles are as relevant now as ever before. While diversification may not seem exciting, it provides some security in times of uncertainty.

Another important lesson from the LDI crisis is the need to factor liquidity and solvency risks at the level of both the overall asset allocation and individual funds held. The LDI crisis demonstrates that even long-term strategies can fall foul of extreme short-term market movements, especially in the presence of high leverage. 

At the client portfolio level, the liquidity risk should be assessed using a range of scenarios, including an assessment of which assets would be sold to meet contingent capital calls. Liquidity assessment has long been an integral part of the portfolio construction process at SEI and it should be expected of any fiduciary manager.

In addition, SEI believes the solvency risks at the level of the LDI fund or vehicle should also be assessed and steps taken to address this tail risk if it is found to be present. We note that reducing leverage in LDI funds will likely reduce both liquidity and solvency risks going forward, and we welcome the higher levels of resilience of LDI funds to yield shocks that is now being encouraged by regulators across Europe.

Clear lessons to learn

The LDI crisis was a testing time for pension schemes, and some emerged with heavy losses. Thanks to much needed intervention by the Bank of England, the worst case scenario—in which highly leveraged LDI funds closed shop due to insolvency—was averted. But the lessons to be learned from this painful episode are clear. A tempering of leverage in LDI funds means the days when schemes could demand both high growth and high levels of hedging at the same time are probably now behind us. At the same time, the LDI crisis has allowed the industry to re-examine what constitutes good fiduciary management.

It is impossible to know for sure where the next crisis will spring from, but we can be prepared. In this light, pension trustees should consider their approach to governance, portfolio diversification and liquidity and solvency risk management. 

Important information

A version of this article was originally published by Professional Pensions

This article 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. While considerable care has been taken to ensure the information contained within this article 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 value of an investment and any income from it can go down as well as up. Investors may not get back the original amount invested. The views and opinions in this article are of SEI only and are subject to change. They should not be construed as investment advice.