The UK’s margin call offers warning signs for public pension funds in the US

The United Kingdom’s pension funds utilize a strategy known as liability-driven investing, where the risk from the market is hedged to keep unfunded liabilities from fluctuating greatly. Liability-driven investing (LDI) is fundamentally different from the typical pay-go or pre-funding structures seen in American public pension systems because it plugs holes in funding from the contributions side rather than employing an investment strategy to do so. LDI is not seen in public pension plans in the United States since they are typically tied to the plan’s assumed rate of return as opposed to market interest rates. That said, there is still a valuable lesson U.S. policymakers can derive from the current pension challenges in the United Kingdom.

How does LDI work? 

In practice, liability-driven investing often involves instruments known as derivatives, which are financial contracts where the value is derived from an underlying asset. For example, a real estate investment trust (REIT) is a derivative of the real estate market. LDI does not necessarily have to involve derivatives and could theoretically use purely physical assets with no leverage. The advantage of using derivatives is that it frees up capital to invest in other areas, such as equities and alternatives. The idea is that you secure your unfunded liabilities from shocks on one end and free up capital to grow your assets on the other end. 

In the case of the United Kingdom, pension liabilities are hedged with a combination of derivatives such as interest rate swaps and U.K. government bonds called “gilts.” The derivatives being used for hedging are sensitive to interest rates (the same rates used to discount the liabilities), which is why they are effective at hedging unfunded liabilities. Interest rate swaps would not be effective at hedging risk for U.S. pension funds since they are pegged to the assumed rate of return as opposed to the market interest rate. In the event that interest rates rise, the fund would have to put up more cash either through available cash reserves on hand or by selling other assets, including gilts, which are very liquid. Conversely, if rates fall, the fund’s counterparty has to put up more cash to the benefit of the pension fund. The fund generally keeps enough cash on hand to mitigate some fluctuation in interest rates.  

Liability-driven investing has grown rapidly in recent years in the U.K., tripling to £1.5 trillion. The U.K.’s reliance on gilts for LDI has made sovereign debt have much longer average maturity periods, around 15 years, compared to its peers in Europe at around eight years or the U.S. at six years, according to Bloomberg. 

Why the sudden selloff? 

When then-Prime Minister Liz Truss’s new tax plan was announced, the market did not feel confident about the fiscal direction of the country, and bond yields spiked by 75 basis points. The spike was so sudden that the pension funds could not simply rely on cash on hand to mitigate the margin call and thus had to sell off gilts to put up more cash. This led to a downward spiral where the high volume of gilts that the pension funds were selling to raise cash for the margin call caused the price of gilts to decrease, which caused interest rates to increase further, thus resulting in a “doom loop” scenario. 

The Bank of England (BOE) did step in and buy a large number of gilts, around £65 billion, thereby stopping the bleeding of the selloff and devaluing of the gilts. However, this may not be enough as the Bank of England would have to continue to buy the bonds until the funds have enough short-term cash. Some pension funds have resorted to selling non-LDI bonds, stocks, and other investments to avoid this doom loop. But in the end, it is still a very messy situation. 

A spike in bond yields and interest rates could be good for pension funds as it means that long-term liabilities are reduced (remember their liabilities are pegged to interest rates and not return assumptions). The issue with LDI in the U.K. is that the pension funds were hedged using those same bonds, meaning that while the debt was being devalued, so too were their assets. 

What can American pension plans learn from this? 

U.S. public pension plans do not rely on liability-driven investing, however, they do have large stakes in private equity and alternative investments. After the U.K. liquidity crunch, Goldman Sachs stated it was seeing a 20-30% discount on private equity funds because investors are discounting illiquid assets in favor of liquid assets. Private equity funds rely on a blend of cash, debt, and equity to purchase assets, and so from the debt perspective, issues could emerge when interest rates rise or the underlying asset, such as real estate, devalues.  

In addition, some public pension funds utilize leverage in their portfolio, such as the Pennsylvania Public School Employees Retirement System (PSERS), which has built the flexibility to invest up to 13% of its total portfolio in private equity and other alternatives. For pension funds utilizing leverage, if there is a margin call and they have to put up more cash than anticipated, they would have to sell assets at unfavorable prices. Public pension funds in the U.S. are generally not directly susceptible to interest rate shocks, but they are indirectly vulnerable and, therefore, should be very cognizant of how much cash on hand they have to handle situations like this. Most U.S. public pension funds have less than 3% of their asset allocation in terms of cash, which is not nearly enough given the recent volatility in the market.