“There is a systemic risk in the UK financial system that nobody has done anything about – it has not been properly regulated.”
The LDI market has grown rapidly over the past decade and is now worth nearly £1.6 trillion, according to the Investment Association. In 2011 it was only worth around £40 billion.
Lord Wolfson’s decision not to tie Next’s pension system into those products now looks like a wise decision.
He said: “What we were encouraged to do then, which we refused to do, we were encouraged to put money, our pension fund money, into index-linked bonds and then use those index-linked bonds as collateral to borrow money on the float and buy more index-linked.” Bonds at a time when index-linked bonds were value-destroying – so there was always a time bomb.”
However, others have defended the investment strategy. Mark Wiedman, a senior executive at BlackRock, blamed the “political turmoil” on market chaos rather than LDIs.
At a conference in New York organized by the Financial Times, Mark Wiedman, head of international and corporate strategy at the world’s largest wealth manager, said LDI investing was going through “teen pains” and that the long-term case for LDIs was “actually really powerful.”
He added: “Here we have a relatively dormant market that has seen very few shocks, including during the financial crisis suddenly going through turbulence caused by policy decisions.”
The amount of government bonds held by pension funds varies, but disclosures show that the Universities Superannuation Scheme, which manages the pensions of 460,000 university lecturers, administrators and other staff, held around £34.4 billion in government bonds at the end of last year. The BT Pension Scheme, the UK’s largest occupational pension scheme, holds around £15.1 billion worth of gilts.
The Funds do not disclose their exposure to LDIs.
Simon Pilcher, CEO of USS Investment Management said: “Coping with the current market conditions has been challenging and has required a lot of management action over the past few days.
“What became clear on Monday was that we were in a very disordered market, particularly in index linked gilts – with levels of volatility not seen in at least 35 years.
Pilcher added that the bank’s intervention was “justified and timely.”
“We continue to monitor these markets very closely and will ensure we are resilient for further challenges,” he said.
Markets settled somewhat on Thursday, with 30-year gilt yields hovering just under 4 percent. Although the bank’s intervention calmed markets and gave pension funds time to replenish their collateral in a more orderly manner.
Ralfe said: “The problem has gotten less severe since the bank’s intervention, but clearly in absolute terms there is still a problem.”
Lord Wolfson said: “If you look at what LDI is about, the goal was to eliminate all risk, eliminate all risk from pension funds completely, and get out of stocks, which have higher long-term returns than bonds, and into fixed rate index-linked bonds, and that has been the trend for the last 15 years.
“What it does is reduce the volatility of your valuation of a pension fund a year from now, but the view we took then and the view we still take doesn’t reduce risk over the long term, and I think we’re seeing that in the future Moment.
“I think the whole way we approach long-term risk in pension funds and the balance between long-term risk and short-term volatility risk needs to be engineered very carefully because I think the mistake people are making was that they thought eliminating volatility was exactly the same as eliminating risk, but since a pension fund’s liability is long-term, short-term volatility shouldn’t really matter. That was our view.”
Ralfe says there should be an investigation into how the bank and Treasury almost allowed a full-blown pension crisis.
While Carney was happy to blame the government for the chaos in financial markets, he and Andrew Bailey, the bank’s current governor, could answer questions of their own about the LDI implosion that almost triggered a complete market collapse.
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