The good, the bad, and the ugly

For a lot of people in the pensions industry, autumn arrived with some unwelcome guests – volatility, uncertainty and anxiety. We can trace their advent back to the now-infamous ‘mini-budget’, unveiled in late September by the former Chancellor, Kwasi Kwarteng.  

The market reaction was merciless. Gilt yields soared, sterling slumped in value, and there were significant consequences for many pension schemes, which use gilts and gilt derivatives in their investment strategies. The resulting dash for collateral – which affected all schemes using leveraged Liability Driven Investment (LDI) strategies – created torrid conditions for pension scheme trustees, affecting both schemes managed in a ‘traditional’ investment advisory way, and those steered by a fiduciary manager.  

In this blog, we take a closer look at how the fiduciary management industry responded to these challenges. We focus on some of the behaviours we saw, but note that the experience for all mandates will be different. 

The good

What benefits did fiduciary managers bring? 

Undoubtedly, the fiduciary management model eased the huge operational burden on trustees. Fiduciary managers were able to sign forms and deal with collateral issues on behalf of clients; some fiduciary managers negotiated accelerated settlements and short-term loans with brokers and managed to agree additional flexibility with counterparties.  

Trustees with fiduciary arrangements were able to sail through the first half of the crisis, and its build-up, without breaking a sweat. They were spared last-minute meetings to discuss rebalancing, and the signing of disinvestment forms to meet collateral calls – which were coming thick and fast. 

Which models worked best? 

Different fiduciary managers can take very different approaches to LDI. Fiduciary managers taking a segregated LDI approach fared better than those taking a pooled approach. This is a trend we saw mirrored in the advisory market. Segregated LDI managers were more likely, and able, to maintain client hedge ratios due to the greater control they can exert compared with managers using pooled arrangements. Clients whose fiduciary managers make use of pooled LDI arrangements were far more at the mercy of the actions of the underlying LDI manager.  

The bad

The perils of being one step removed 

Broadly speaking, trustees with fiduciary management arrangements are further from the nitty gritty. This has many pros, but also, as we found out, some cons. During the recent turbulence, it meant that many trustees were not fully aware of the extraordinary market situation and the implications for investment portfolios until much later than trustees with advisory arrangements. Firstly, trustees with advisory arrangements were much more aware of the collateral management considerations required because they had debated and implemented collateral management decisions months beforehand, in the first half of the year, when long-dated gilt yields were rising quickly (but not precipitously). Secondly, when gilt yields rapidly took off in the days following the mini-budget, trustees with advisory arrangements were convening short-notice meetings and signing transition paperwork, while those with fiduciary arrangements were blissfully unaware, because this activity was all going on behind the scenes.  

However, things eventually reached a tipping point when many fiduciary mandates were pushed to their limits and lacked confidence that they could maintain the same level of liability hedging while meeting their current growth targets. At this point, many fiduciary managers asked their clients to change the terms of their mandate, often at very short notice.  

Short-notice requests for sweeping changes to mandates raise eyebrows 

It was early October when we saw many managers asking clients for discretion to cut liability hedge ratios (or to lift restrictions around investment guidelines). Changes to liability hedging levels can have huge impacts on the funding levels and deficits of pension schemes. For a typical pension scheme, liabilities can rise or fall about 20% for every 1% change in long-dated gilt yields. In the recent market turmoil, we saw liabilities move by more than 20% in the space of a week and sometimes even a day. Being 100% hedged, versus 50% hedged, would have made a massive difference. Rather alarmingly, we saw:  

• Some fiduciary managers asking for unlimited discretion on reducing hedge ratios.
• In many instances trustees were given little reasoning around how, and to what extent, this discretion would be used. 
• These requests for discretion being applied across a fiduciary manager’s client book in almost blanket fashion, even where it was not required. For example, schemes with low-risk portfolios and ample spare collateral were asked to allow their fiduciary manager unlimited discretion to reduce hedging assets on their behalf. 

Pooled fund failures 

As mentioned earlier, clients whose fiduciary managers make use of pooled LDI arrangements were often at the mercy of the actions of the underlying LDI manager. For example, some fiduciary managers ran into difficulty when the collateral in the pooled funds they used reached such low levels that client liability hedging levels were forcibly reduced by the underlying investment managers. For many, this happened just before the Bank of England stepped in and yields went dramatically into reverse, which meant that they ended up selling at a low point in the market and then re-buying after prices rose. This even affected schemes with highly liquid growth portfolios because the underlying investment managers needed extra collateral with less than one day’s notice, which was impossible to provide even if assets were sat in daily dealt funds. This will have hurt funding levels, sometimes significantly.  

To be clear, this problem also affected many schemes that make use of an advisory model rather than a fiduciary model. However, this experience gives the lie to the common perception that fiduciary management has some magic dynamism that always leads to better outcomes. In this instance, everyone was in the same boat – whether they’d paid for an advisory ticket or a fiduciary one. 

The ugly

One of the challenges for trustees with fiduciary manager arrangements can be trying to understand all of the many steps that fiduciary managers have taken on their behalf, especially the ones that had a significant impact.  

Worryingly, we saw instances where bad outcomes were swept under the rug, and communications that should have been key updates buried in long emails or presentations. For example, we saw some schemes lock in substantial losses when their fiduciary manager had failed to maintain the target level of hedging over the volatile period, and re-bought gilt exposure at higher prices. But the update from the fiduciary manager was that hedging had been reduced to protect the client and, unsurprisingly, they didn’t want to dwell on the pound and pence effect this had on the scheme’s deficit! 

For any trustee reading this who thinks they still don’t have the full picture, make sure you ask your fiduciary manager these questions: 

• Were target levels of hedging maintained throughout the period from 23 September to 30 September (the first spike in yields)? If not, why were they reduced and were hedging levels re-raised following the reduction? If so, what was the effect of this in terms of funding level in percentage terms and monetary terms? 
• After 30 September, were hedging levels adjusted? If so, what were they before, and what are they now? What has been the effect of this in terms of funding level percentage terms and monetary terms? 
• Do you think our investment strategy should change going forward? Will we need to accept more funding level volatility in the future? If so, what is the expected difference in rising yield scenarios as well as falling yield scenarios? 

To sum up...

The good outcomes

• There was a clear operational benefit for trustees with fiduciary mandates who didn’t have to deal will a wave of short-notice collateral calls with short-notice meetings and paperwork to sign. 

The bad outcomes

• The operational benefit came at the cost of not being as close to the day-to-day decisions as the crisis evolved. When the exceptional market conditions pushed many mandates to their limits, many trustees were caught unawares as their fiduciary managers asked them to change their investment guidelines at very short notice.  
• Some fiduciary managers that make use of pooled LDI solutions ran into difficulty and liability hedge levels were forcibly reduced, even when total portfolios were very liquid and had plenty of collateral. This hurt funding levels. 

The ugly outcomes

• We saw instances of bad outcomes being swept under the rug and key updates buried amid wider communications.  
• We expect there are many trustees out there who don’t understand how their fiduciary managers handled the crisis. They won’t know if  the fiduciary manager took actions that led to bad outcomes.  

Final thoughts...

The misconception that fiduciary management can be a ‘set and forget’ solution has been shattered. It’s clear that there will always be a point where difficult questions come back to trustees. This could be regarding the introduction of a new asset class, a question around performance targets and fees, or, as we saw recently, when market conditions change so much that investment guidelines require rapid adjustment. Trustees should be ready for these questions in future. Staying close to mandates in the market lulls, sense-checking key investment decisions from your fiduciary manager and discussing the alternative options which were considered and dismissed can help prepare trustee boards for these questions when they come.  

As the year draws to a close, let us hope that we’ll see less of volatility and uncertainty, and more of calm and predictability, so that trustees can take stock and answer the big question on everyone’s mind: how should investment strategies evolve to cope with the ‘new normal’?