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Lessons for DC schemes from the LDI crisis

James Fouracre
Director – UK Institutional

Last month’s crisis in the UK gilt market shook many defined benefit (DB) pension schemes to their core. 

The blow up of liability driven investment (LDI) strategies damaged many DB schemes and the effects are rippling throughout the pensions industry. So what can defined contribution (DC) schemes learn from the experience?

  1. Government bonds are risky, and some riskier than others
  2. Decumulation is not the time for speculation
  3. Correlation matters when everything falls together
Bonds can be risky too

“Up in the city, I tried for a while to list the quotations on an interminable amount of stock, then I fell asleep in my swivel-chair. Just before noon the phone woke me, and I started up with sweat breaking out on my forehead.”

Those are the words of Nick Carraway, narrator of The Great Gatsby. He was a bond salesman on Wall Street in the early 1920s. And bond traders today will have felt a similar sense of feverish panic as gilt prices plummeted following the UK government’s mini-Budget last month. 

The chart above shows the extraordinary volatility of the 2073 UK conventional gilt during the last week of September. We witnessed daily returns of -5%, -7%, -13% and then a further-13%. 

Gilts, used as a means of mitigating risk and providing steady and reliable returns, exhibited characteristics more commonly associated with the most speculative of assets – growth equities or even cryptocurrency.

The fluctuations of long-dated government debt served as a timely reminder of the duration risk pension investors take on when they purchase these assets. Duration risk can be, and at times will need to be, carefully managed in portfolios.

Decumulation is not the time for speculation

Equities are the dominant asset class for most of a DC scheme members’ investment lifecycle, given the long-term investment horizon. But bonds are increasingly called into play as members approach retirement and in the decumulation (post-retirement) phase. Government bonds, or gilts, are generally regarded as a more cautious and protective source of returns – lower risk, ostensibly, than equities.

But as we’ve seen, owning certain bonds is speculative too. The timeframe matters.

Many individuals intending to retire in the near future will have suffered material losses to their capital. Some simply will not have time to recover that lost ground. The drastically shortened investment time horizons of scheme members in the ‘pre-retirement’ phase and even more so in the decumulation period, changes the psychology of portfolio construction. 

It speaks to the old adage that ‘time in the market beats timing the markets.’ For investors who cannot afford the former and are unable to do the latter, an alternative approach is required.

Correlation matters when everything falls together

As individuals and organisations inspired by driving better outcomes for DC members, what do we learn from the dramatics of late September? Are bonds still the low-risk, low-volatility investment tool they once were? 

We think, perhaps not. We are entering a regime of higher inflation volatility. One that will bring more interest rate volatility and a greater need for investors to manage duration risk. As we’ve seen throughout 2022, the pain is greatest for investors when all assets fall together.

There will be times when investors will want exposure to bonds, and the duration that comes with them.  

But the key is being able to turn the dial on that exposure when necessary – you need an agile portfolio. One that uses unconventional instruments as a source of uncorrelated returns – think derivatives in credit, equity protections and alternate currency positions.

The Ruffer portfolio is an uncorrelated and liquid alternative, both to equity risk and fixed income risk. In September, we held protections which actively offset interest rate risk of the inflation-linked bonds in our portfolio. We were able to move swiftly, and to take advantage of depressed prices to benefit when the Bank of England intervened to restore stability.

Being nimble and focusing relentlessly on the preservation of capital will be essential as markets move deeper into uncertain territory.

But what about the argument which says lightning won’t strike twice – bond investors won’t make the same mistake again? After all, Nick Carraway, our bond salesman from earlier, warned his neighbour and friend, “You can’t repeat the past.”

But it’s Gatsby’s response which may provide the lesson for asset allocators. “Can’t repeat the past? he cried incredulously. Why of course you can!”

DC pensions schemes and their investors must learn the lessons from the UK gilt debacle. Because in a world which promises ever more risk and volatility, we must be prepared for the unlikely – not least, history repeating itself.

DC pensions
Investor behaviour is both instinctive and learned. Low interest rates have taught investors to allocate to ever-riskier assets in the pursuit of returns. The cost of doing so, in the form of low or negative 'risk-free' rates, was minimal. But with rising interest rates, the risk-free rate now carries value - investor behaviour may be forced to change once again.
Read
DC pension schemes
Conventional strategies have served defined contribution (DC) pension scheme investors well for the past half century. But this year – as inflation has taken hold and policymakers scramble to contain it – the vulnerability of bonds and equities has been laid bare.
Read

Chart source: Bloomberg, data to 27 September 2022

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. References to specific securities are included for the purposes of illustration only and should not be construed as a recommendation to buy or sell these securities. This article does not take account of any potential investor’s investment objectives, particular needs or financial situation. This article reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. Read the full disclaimer.

London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France