Why does a stitch in time save nine? The LDI Crisis – how can we be better prepared?
When I was a kid, every time I was caught on the back foot my mum would say “a stitch in time saves nine”. Roll forward 40 odd years and it makes me smile and think more of grannies darning socks, but there is a serious point behind it. Not being prepared for what might happen has consequences which can go way beyond a holey sock.
As the fall-out from the LDI crisis last year begins to gain early momentum with some focus on the legality of what happened, Trustees don’t need to wait for the Work and Pensions Committee’s report nor the outcome of any litigation which may ensue to act.
Each pension scheme will have its own lessons to learn and if each Trustee is to “get the darning done” they owe it to their members and sponsors to properly consider the extent to which the LDI crisis was a surprise, how well they responded to it and whether there are things that could have been done differently.
As well as Trustees considering this, advisers need to do the same – did we do enough?
The lessons learned are often themes that apply to several areas of pension scheme operations. This is not just planning for another LDI crisis, but is useful preparation for the next challenging and unexpected issue which may arise whatever it might be.
In the aftermath of the LDI crisis a few issues have already come to light. These include:
- The herding instinct: The realisation that too many schemes were huddled around the same brazier looking for the warmth of LDI in a long cold winter of low interest rates. Some of those schemes had been encouraged to herd around this particular brazier even where they were unsure if LDI was for them. This is something Sir Paul Myners argued schemes should not do well over 20 years ago – yet here we are again!
- Modelling blindness: The over reliance on the truth of the models and the idea that the fact something has never happened before equals it will not happen in future. Yet we all know that the worst kind of risk is the unprecedented event. We witnessed a few lay trustees in the early summer being “patted on the head” by advisers when they asked why gilt yields could not rise like the base rate. Why would gilt yields not move like short term rates such as when the UK fell out of the ERM in the early 1990s when interest rates rocketed in a morning? As it turned out that was a very good question.
- Inadequate collateral stress testing: We did see some trustees reconsider LDI in the summer in the light of rising interest rates and insist on new stress testing of their collateral waterfalls based on higher gilt yield expectations including extreme scenarios. Looking at those stress tests now, they look inadequate. In some cases, the extreme case would have been a good outcome. There was a real reluctance to include an “Armageddon” scenario of what things would look like when the collateral ran out or did not get there on time. Such scenarios should be kept in perspective, but they help if anything like Armageddon happens as people tend to move past panic to action stations more quickly.
- The free lunch: Over the years LDI has had more and more bells and whistles added to it so adding leverage. In benign times this is a weight LDI can carry. But in a crisis it can’t. Lay trustees who asked if high levels of leverage were a free lunch were told 5+ times leverage was perfectly normal. Some schemes were even told they could not afford to have leverage below these levels. Highly levered LDI is a free lunch that has to be paid for; the only question is when.
- Unclear objectives: Were schemes to defend their hedges no matter what or were there circumstances where reducing the hedges was a risk worth taking? Some schemes and sponsors were in close collaboration with advisers on both sides problem solving, sharing and testing this very question. But not all were.
- Inadequate crisis governance: Schemes relied heavily on the idea they would have several days to post collateral on the basis that legal documentation saying, “up to 10 days” was treated as “10 days”. Plenty of time to post evaporated in a morning. Schemes which had governance structures that allowed them to move to “action stations” quickly were nimbler than those that did not. In a crisis, the difference matters.
- Human resource: Who knew that LDI requires complex calculations to work out hedging levels and collateral or the extent to which people, not computers, need to input? The crunch in human resource proved the undoing of some and presented some “squeaky bum” moments for others.
These are enough potential holes in any sock heel to keep an expert darner at work for some time.In addition, the Pensions Regulator has also published guidance on stress testing which goes way beyond what most schemes have done in the past. But stress testing alone is unlikely to be enough either for a repeat of the LDI crisis or indeed any other challenging event. Schemes should have an open debate on what issues they faced, what behaviours their trustees and their advisers displayed, and what could have helped to improve the outcome of what happened.
Doing this type of broader thinking should leave your scheme better ready for any type of crisis, not just a re-run of the LDI crisis.
Arc Pensions Law has produced two previous newsletters following this topic:
“High inflation and rising interest rates: Should Trustees be worried?” was published in July
2022 and can be found here.
“LDI – Surf’s Up!!!” was published in October 2022 and can be found here.