Beyond Bulls & Bears


UK vs. US pensions: The risks of derivatives-led LDI approach

It is unlikely that US corporate defined benefit (DB) pensions will have to face liquidity issues like those UK DB pensions recently witnessed, primarily because of their different approach to valuing liabilities, varying use of derivatives/leverage, and therefore a different investment style of liability-driven investing (LDI), according to Franklin Templeton Fixed Income’s Tom Meyers.

In the United States, corporate defined benefit (DB) pensions discount their expected future benefit payments using a corporate bond-based discount rate. Typically, they offset (or hedge) this obligation with a corporate bond-driven, liability-driven investing (LDI) approach using predominantly physical (cash) bonds with a similar duration to that of the liabilities. This reduces the interest-rate risk of the plan to the sponsor/employer, as the bonds and the liabilities move together as interest rates change.

DB pension plans in the United Kingdom use a different approach, as a response to directives mandating the use of long-term bond rates to determine the value of their pension liabilities. This includes not just yields (gilt-based) but also an assumed inflation rate. In addition, the magnitude of UK liabilities is larger than in the United States, where the advent of defined contribution plans has moved much of the variability of returns onto the individual.

In response, UK pensions have commonly used derivatives to achieve greater capital efficiency in reaching target hedge ratios and higher targeted rates of return.

However, as with any strategy using leverage, this approach magnifies both gains and losses. Increased yields year-to-date have meant losses across fixed income sectors in 2022. On top of this, the sharp rise in gilt yields following the UK’s “mini-budget” in September led to significant declines in the nominal value of interest-rate derivatives held by pension funds, requiring massive collateral calls. As pensions liquidated their other investments, prices plummeted. The surge of trading activity took place while global markets—apart from the United Kingdom—were showing signs of stability. This period of turmoil within the United Kingdom shows how fluctuations in developed economies are rattling financial markets worldwide in unexpected ways. Forced selling by UK pension investors has also impacted US financial markets.

A key culprit is leverage. British pensions can allow a 1-7x leverage ratio. That means managers are permitted to purchase exposure to fixed income assets equal to as much as seven times the amount held in their fixed income portfolio.

However, despite the difficulties their British counterparts face, we see less of a cause for alarm in the United States. First, exposure to derivatives is much smaller for US pension funds compared to the United Kingdom. They are still used though, primarily for hedging foreign currency and interest rate risks and are reported at fair value. Typically, US funds favor the use of less overall leverage or borrowed money. Also, the relative scale of corporate DB liabilities is far less in the United States, where companies have offered mainly defined contribution plans since at least the early 2000s. In short, given the different approach to valuing liabilities and managing assets against them, in our view, it’s unlikely US corporate DB pensions will confront the liquidity turmoil UK DB pension plans faced.


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