I cannot remember the number of times I walked into meetings to discuss Asset – Liability Matching (ALM) with pension funds and insurance companies. Insurers fell into two buckets – the savvy ones running sophisticated matched portfolios and the others with serious mismatches. Pension funds, alternatively, either lacked instruments to reduce the mismatch or fell into the trap of treating equities as ‘long duration’ proxies for their liabilities. I had some success with insurers but none with pension funds.
Liability Driven Investing (LDI) is the same as ALM. LDI had an amazing following in the UK amongst pension funds. The idea is that defined benefit plans have actuarially predictable liabilities with long duration profiles. Typically a fund would buy equities and hold short term bonds to generate a return sufficient to reduce the cost of the pension liability but this often meant there was a mismatch between assets (short-term) and liabilities (long-term). As interest rates fell the liabilities increased more than the assets leaving a hole in the fund that required additional funding by the corporate. LDI promised to plug this hole.
Aided by derivatives, it was possible to create long dated assets to match liabilities. A 10 year Gilt future has about a 7 yr duration. To match a 21 year liability all you need to do is buy 3 times the number of futures per dollar liability and , voila, you are matched. But while every problem has a solution, every solution has a problem…
Margin calls. Cash Settlement Agreements (CSAs) are methods for ensuring that credit risk is diminished in derivative markets. As prices fluctuate, actors are expected to contribute and settle up balances owing or receivable during the life of a contract. For LDI portfolios, however, only the asset side of the trade is subject to CSA or margining. Liabilities move in value equivalently to the assets but do not fund the margins. Therefore, for instance, if Gilt futures fall in price by GBP10 per contract, the cash margin requires GBP10 to be contributed by the pension fund per contract which in the example above would be 3 times higher to extend the duration. Liabilities would increase in value but generate no CSA. Therefore there is an interim cash crunch where there is insufficient cash to meet margins despite the net value of Assets minus Liabilities being unchanged. This nightmare scenario occurred last week in the UK where a perfectly reasonable risk controlled strategy had to be unwound to meet margins.
The unwinding caused a sell off in Gilts that brought the market to its knees triggering Bank of England (BOE) intervention. The main culprit for all this sits with the Accounting rules that do not recognise the Asset-Liability match and, secondarily, the CSA margining rules. Marking to market a liability stream creates accounting difficulties so these are sometimes left off-balance sheet or held constant at actuarial valuations from several years previously. Assets, on the other hand, are marked every second with margining often daily but sometimes at longer intervals. So even though the A’s and L’s are M’ed there is no way to use the gains on the L’s to meet the margins on the A’s losses.
This leaves the LDI industry in a conundrum and the BOE stymied. The basic idea is sound and therefore the market regulator cannot be critical of the practice. Accountants have always done their own thing no matter how wrong or intransigent. The derivatives markets rightfully want their credit risk controlled. What LDI needs is a natural hedger with the opposite liability profile to the pension funds to deal together so that they bypass the CSA’s. The natural long dated borrower is the BOE.