Liability-driven investment (LDI) introduces extra risks to pension schemes, is a foolish financial product and also technically illegal, a UK pensions expert claimed in a video event last night.
Con Keating, head of research at Brighton Rock Group, an insurance company for pension schemes, said as keynote speaker at the event hosted by the organisation Transparency Taskforce that the LDI crisis following the government’s mini budget in September had been bound to happen.
“Let’s do away with the idea this was a black-swan event. It is not. It was certain to happen at some point or another,” said Keating, who also gave evidence this morning to the UK parliament’s Work and Pensions committee hearing evidence on defined benefit pensions with LDI strategies.
Keating said in the keynote speech last night that the “death spiral” associated with index-linked Gilts in September had been driven by leverage, and this had been the cause of the Gilt crisis.
“The question is why are pension schemes using liability-driven investments? And the answer to this lies in an accounting standard and regulatory evaluation processes,” Keating said.
Referring to a graph showing a smooth curve representing the amortisation of pension contributions over 30 years, he contrasted it to the up-and-down nature of market interest rates at various points along the line, illustrating why hedging might be seen as necessary.
He said the rate at which a pension was amortised was not a risk to the pension.
“It is a cause of variabilities in the intermediate valuations, but they are not a risk in and of themselves to the pension,” he said, adding that one could argue that hedging the interest rate on those grounds alone was ultra vires for pension trustees.
“So almost certainly the operations known as LDI are illegal”
Con Keating
In another point, Keating said the regulatory approach to hedging pension scheme liabilities had been wrong partly because when interest rates went down, company profitability increased, so there was an intrinsic hedge between a company and the pension scheme.
Keating argued that in itself, the variation between a pension scheme’s assets and liabilities did not matter.
“If you do start hedging using conventional Gilts, you are actually introducing a sensitivity to interest rates, you are effectively long long-dated Gilts in your pension scheme.
“And as long as interest rates decline, you do well. And for 20 years schemes have done well out of LDI. But of course when rates start rising you lose money,” he said.
“Perhaps the ultimate damnation of LDI is this – the variability does not matter unless we take action on it,” he said.
“LDI is basing all of our actions on it. It is the ultimate folly,” he said.
Keating said The Pensions Regulator stated that repo financing, because it was structured as a sale and future repurchase of an asset, was not borrowing.
“Well, its borrowing in all but name,” he said.
On the legal situation, Keating said the relevant piece of law in this regard was the original IORP legislation, which said schemes could only borrow for liquidity purposes on a temporary basis.
However, he said, schemes were borrowing systematically, and regulators knew this.
On the use of derivatives by pension funds, Keating cited European law, which he said was still the relevant legislation in the UK, and stipulated that investment in derivative instruments should be possible insofar as such instruments contributed to a reduction in investment risks.
“These derivatives are being used to hedge a non-existent risk – interest-rate risk – and inflation and various other risks which are liabilities,” he said.
Keating said that although the UK transposition of that law omitted the adjective “investment” to qualify “risk”, if tested courts would look to the original law for the meaning here.
“So almost certainly the operations known as LDI are illegal,” he said.
“Schemes are borrowing, schemes are hedging with derivatives, – liabilities that is – and schemes are hedging illusory risks, that’s discount rates,” he said.
Keating said pension schemes have become short-term market-sensitive institutions supplying liquidity to markets when it is stressed and expensive.
“And they are doing it for free,” he said.
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