Pension fund strategy that caused chaos in the UK was less common in Canada

Bond market collapse recalled ‘death spirals’ of the 2008 financial crisis

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The bond market turmoil that gripped the UK last week is unlikely to repeat itself in Canada, as the pension fund strategy that caused the problems is not as prevalent here, pension experts say.

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Liability-driven investing (LDI) strategies, designed to hedge the long-term obligations of pensions to their beneficiaries through the use of derivatives, led to a sell-off in bond markets after a rapid rise in interest rates forced funds to liquidate their positions .

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The incident brought back memories of “death spirals” and contagion last seen during the 2008 financial crisis and although the UK’s central bank intervened with the purchase of government bonds to ease the ripples, it is not clear whether the situation has come to a halt.

This time around, the catalyst has been regionally isolated – the markets’ response to specific new UK financial policies, driving yields up – but it has focused pension watchers on other jurisdictions where pensions adopt similar LDI strategies, including the United States and Canada.

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LDI strategies are used to reduce the risk of a pension failing to meet its obligations well into the future by hedging against economic factors such as falling interest rates and rising inflation. Swaps and other derivatives are often used that use leverage to free up capital for investment, allowing a pension to focus on growth strategies at the same time.

“That’s a strategy used in Canada for Canadian occupational retirement plans, as well as in the US,” said Ben Ukonga, director at Mercer LLC and leader of Calgary’s retirement and benefits consulting firms. “But my understanding is that a (wider) portion of business plans in the UK are using these strategies. In Canada… it’s a much smaller percentage of the plans out there.”

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In addition, he said, Canadian pension plans that use LDI strategies do not leverage to the same degree as those in the UK. — are indexed to inflation.

Liability-based investment strategies gained popularity more than a decade ago in the wake of the global financial crisis, but they had not yet been tested in periods of rapidly rising interest rates and falling bond prices. However, last week in the UK, falling government bond yields rose, causing the collateral pensions they had committed to support their LDI strategies to decline.

Pensions “essentially had margin calls or collateral calls,” Ukonga said. Forced to raise money quickly, investment managers turned to something they could easily sell: government bonds.

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This “further increased yields and it started to spiral out of control,” Ukonga said, adding that “there are analogies” to the global financial crisis of 2008. “Every time you use leveraged products, there is always a risk of margin calls. .”

When the Bank of England quickly reversed its fiscal tightening stance and started buying government bonds, it stopped the spiral, but the key question left, he said, is what will happen if the central bank reverts to its promise to end. to quantitative easing and stop buying the bonds.

As for Canada, Ukonga does not expect a major impact from the obligation-based investment strategies used in occupational retirement plans.

“I’d say it’s not impossible, but it’s… a smaller chance,” he said. “Not low probability, lower probability.”

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Meanwhile, Canada’s largest pension funds, such as the Canada Pension Plan Investment Board and the Ontario Teachers’ Pension Plan Board, are not expected to face the same challenges as smaller business plans.

“I don’t think the bigger plans have taken advantage of the strategy because there isn’t enough liquidity in the Canadian interest rate derivatives market to implement the strategy,” said Jim Keohane, former CEO of the Healthcare of Ontario Pension Plan. (HOOPP) and director at Alberta Investment Management Corp. “So most would get their interest rate exposure through physical bonds rather than derivatives.”

Keohane said he is aware of some business plans and smaller plans that have used the strategy to try to “immunize” themselves against long-term liability risks using interest rate futures or swaps.

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“So it’s possible that if Canadian government bonds went through a serious overnight move, similar to what happened in the UK, the same problem could arise, but on a much smaller scale,” he said.

“For any leveraged strategy that uses derivatives, managing liquidity is the Achilles’ heel. You need to make sure you have enough access to liquidity to meet margin calls under severe market scenarios.”

Another senior Canadian pension official said plans with a surplus on their liabilities, or long-term guarantees, can handle such short-term challenges, adding that higher interest rates will help some longer-term plans by reducing their liabilities.

Persistent, long-term inflation is the bigger threat, he said, for those whose liabilities are indexed to rising costs.

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