Mini Budget Crisis – What’s the damage? Part 1

8th December, 2022

  • With the Chancellor’s Autumn Statement now well behind us and the markets appearing to be satisfied for the moment, there is some time to pause and reflect as to what went right and what went wrong.  Personally, I spend most of my risk management life considering the latter unless the former was also a surprise! 

    Looking at the aftermath of the “Mini-Budget Crisis” (MBC) I have a real concern that the anti-LDI cohort (and there are quite a few in this group) can say “I told you so”, thereby attempting to deny the immense value that the LDI proposition has made for millions of scheme members.  Calling for LDI programmes to cease started way back in the mid-00’s: “why invest in gilts when you can invest in equities” was a constant refrain from sponsors and this got louder and louder the more yields fell.  In their defence, as in Rudi Dornbusch’s defence, at some point they were always going to right (probability theory dictates as such).  Just like those who, from a macro economic basis, argue that the Euro is going to collapse.  But, as ever, timing is everything and those who hindsight trade often forget that. 

    So, from my perspective, LDI was, is and will always be a structural part of any pension portfolio risk management framework until the rules and laws stop dictating that my (and my sponsor’s) actuarial liabilities are directly linked to GBP risk free rates.   When that stops, I will only be interested in what they are linked to.  I suspect that break is not going to happen soon: it is not just a DB pension issue but also a solvency issue (assuming that UK revision of Solvency II is not going to break that link either….hopefully the incumbents in Downing Street are not going to try that one on). 

    As of today, my liabilities are solely characterised by being short rates, short inflation and short longevity.  So, to hedge myself, I need to have assets with the opposite characteristics.  I am not good at taking directional risks: if I was, I would be a billionaire, like Louis Bacon.  My job is to secure the existing liabilities and have assets of equal measure: not more or less.  I am not here to trade markets: there are a lot of people who think they are and at least 50% are mistaken. 

    So how did schemes get damaged by the MBC? Poor liquidity planning brought about by either a lack of understanding or a lax view on risks.  The combination of low funding and a desire for high hedge ratios was potent: schemes wanted to shut down funding level Value at Risk (VaR) because the sponsor was not capable of withstanding much of a drawdown.  If the sponsor was strong, it would likely or could have funded the scheme better.  So the drive for high hedge ratios by the least funded with weak sponsors was entirely logical.  And smaller schemes did not have access to the segregated LDI pools, adding another layer of complexity and another layer for rapid communications and responses to be muffled by. 

    The scheme most likely to be worst off (by percent of damage done) was: 

    1. Smaller than average 
    2. High hedge ratio 
    3. Lower funding level 
    4. Operating off an “investment platform” 
    5. Invested in a pooled LDI fund 
    6. Allocated non-trivially to illiquid assets 
    7. Inexperienced consultants (i.e. do not understand the collateral implications of derivatives) 
    8. Inexperienced trustees (i.e. do not understand the collateral implications of derivatives) 

    In part 2 of this blog, I will review each of these points in more detail. Read part 2 here .

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    • Published byPaul Brine

      Paul has over 16 years’ experience as a trustee (including 10 years as an independent), having served on a variety of schemes from £50mn in assets to £3.5bn, across defined benefit, defined contribution, and hybrid structures. Paul has also chaired...

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