UK Vs. US Pensions: The Risks of Derivatives-Led LDI Approach

In the United States, corporate defined benefit (DB) pensions discount their expected future benefit payments using a corporate bond-based discount rate. Typically, they offset (or hedge) this obligation with a corporate bond-driven, liability-driven investing (LDI) approach using predominantly physical (cash) bonds with a similar duration to that of the liabilities. This reduces the interest-rate risk of the plan to the sponsor/employer, as the bonds and the liabilities move together as interest rates change.

DB pension plans in the United Kingdom use a different approach, as a response to directives mandating the use of long-term bond rates to determine the value of their pension liabilities. This includes not just yields (gilt-based) but also an assumed inflation rate. In addition, the magnitude of UK liabilities is larger than in the United States, where the advent of defined contribution plans has moved much of the variability of returns onto the individual.

In response, UK pensions have commonly used derivatives to achieve greater capital efficiency in reaching target hedge ratios and higher targeted rates of return.

However, as with any strategy using leverage, this approach magnifies both gains and losses. Increased yields year-to-date have meant losses across fixed income sectors in 2022. On top of this, the sharp rise in gilt yields following the UK’s “mini-budget” in September led to significant declines in the nominal value of interest-rate derivatives held by pension funds, requiring massive collateral calls. As pensions liquidated their other investments, prices plummeted. The surge of trading activity took place while global markets—apart from the United Kingdom—were showing signs of stability. This period of turmoil within the United Kingdom shows how fluctuations in developed economies are rattling financial markets worldwide in unexpected ways. Forced selling by UK pension investors has also impacted US financial markets.