By Danielle Markham FIA, Principal and Senior Investment Consultant at Barnett Waddingham
However, the immediate priority will vary considerably from scheme to scheme depending on liability hedging level, funding position and maturity.
Weathering the storm
The practical focus for many schemes with leveraged Liability-Driven Investment (LDI) in place has been to ensure that liability hedging levels can be maintained as far as possible over such a volatile period.
Whilst schemes were generally very well placed to withstand a large call for collateral to reduce leverage (for example by having robust collateral waterfalls in place to automate the de-leveraging process as far as possible), markets have been moving at such a pace that further action has often been required to rebalance portfolios to ensure that this remains the case. As gilt markets have moved even further, and other asset classes are also feeling the strain, schemes will need to be nimble to adjust their strategy to deal with this volatility and to keep a step ahead of further rate rises.
Schemes should also give consideration to the design of their LDI portfolios. Most hedging portfolios and liability benchmarks were designed when long-term yields were under 2%, not around 5% as they are now. Many schemes will find that their hedges are no longer in the optimal form and hedge ratios may have drifted materially away from target. Schemes should at least understand this effect.
Improvements
The more exciting challenge is how schemes can lock into improvements in funding position. The majority of schemes will have seen the shortfall against their long-term funding position materially reduced. Schemes hedging materially less than the value of their assets against interest rate movements will have seen a stark reversal in fortune and now find themselves able to approach their endgame sooner than expected. Being able to lock into this improvement by de-risking now will help to ensure that this actually materializes over the longer term.
That said, we foresee a short-term supply/demand imbalance in the insurance buy-out market. Supply is currently constrained by practical resourcing considerations, whereas demand is driven mostly by scheme funding levels. Insurers are likely to be increasingly picky about which deals they quote on and which they don’t.
If demand does grow quickly, then it will become even more important to position your scheme attractively to the insurers to get their attention. Ensuring your scheme has both a clear plan to approach the market (with all stakeholders on board), and data and benefits in shipshape condition will be critical to success. Otherwise, trustees may find they simply can’t get a quote.
Finally, there is an interesting interaction between the rise in gilt yields and TPR’s new Code of Practice on DB funding. The new regime will require schemes to be fully-funded on a ‘low-resilience’ basis by the time they are ‘significantly mature’. The problem is that ‘significantly mature’ is defined by reference to a scheme’s liability duration, which is itself a function of gilt yields.
The remarkable rise in gilt yields will bring this date forward by several years for most schemes, reducing the time they have left to deal with any remaining deficit. Whilst not likely to be a problem for schemes who have seen their funding positions improve significantly, those schemes with high liability hedge ratios may need to readdress their journey plans, especially if they were relying mostly on investment returns to bridge the gap.
Whilst riding the volatility in markets may feel uncomfortable in the short term, schemes that can keep their cool and take decisive actions may well find themselves in a more robust position going forwards.
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