The volatility in the gilts market following the chancellor's mini-budget last month pushed several UK business defined benefit (DB) plans to the edge of insolvency.
Ironically, the yield swings that sparked the panic were beneficial to the plans' long-term financing levels. The issue was the rate at which rates rose, as a flood of collateral calls left schemes desperate for cash.
Local Government Pension Scheme (LGPS) funds face a unique set of challenges. Because LDI is employed on a far smaller scale than corporate DB schemes, we are unlikely to see such systemic issues. Because their asset base is free of LDI risk, many LGPS funds will have reaped the full benefit of a liability reduction. Nonetheless, if LGPS funds are to capitalise on this windfall, there are still lessons to be learned from the events of late September.
The root of the problem for corporate strategies was liquidity, not politics or leverage. A synchronised market sell-off meant that cash was required quickly. In comparison to the plans, the amount of cash was not very substantial. However, after pursuing returns (and income) for more than a decade, many of the risk assets currently owned by corporate schemes are illiquid. It's simple and attractive to enter, but far more difficult to leave in a hurry.
Given their larger requirement for investment returns, LGPS funds have been particularly aggressive in their pursuit of yield. The tale of the 2010s was one of a rush towards illiquid alternative assets. This pattern has persisted since Covid-19.
LGPS funds may not get collateral calls on the same extent as corporate DB schemes last month during times of crisis. They do, however, have a continuing obligation to pay pensions. Many others want liquidity to satisfy committed capital requirements or just to capitalise on the possibilities that market instability might provide long-term investors. A portfolio in which liquid and illiquid assets, growth and income assets, and stocks and alternatives all move in the same way during times of stress cannot provide this.
What is our recommendation? As strategic asset allocation season approaches, LGPS funds should carefully assess how to achieve diversification in a more volatile environment. The addition of a liquid and uncorrelated technique may assist to reduce risk.
This might be critical not just for satisfying commitments but also for capitalising on opportunities amid market turbulence, as some corporate DB schemes discovered to their relief in late September.