Sonia discounting and the Whac-A-Mole world of LDI

Imagine you’re a trustee of UK defined benefit pension scheme and you’re in this quarter’s investment committee meeting.  Just after the scheme secretary has gone though the actions log and before you hear your consultant’s latest investment idea, your actuary presents an update on your funding position.  If you are like most UK pension schemes, chances are your actuary will explain that although your investments generated healthy returns during 2014, your scheme’s funding position nevertheless deteriorated as a result of lower interest rates, but fortunately you and your fellow trustees protected your scheme against this very scenario.  Several years ago you established an LDI strategy and in this meeting you learn that you weathered last year’s decline in interest rates relatively well and that your funding level actually improved by a few percentage points.  While you are probably feeling quite relieved that your scheme is in a comparatively good position and remains on track with respect to its journey plan, be prepared – your situation is not all good news.

For schemes that have existing LDI programmes, there is a potentially tricky discussion looming with your LDI manager that could darken the relatively rosy picture painted above and it has to do with the discount rate that the market uses to value your swap hedges.  Following the Global Financial Crisis, the market moved from Libor discounting when valuing swaps to a valuation rate more in line with the rate paid on the collateral posted in the swaps.  Where a pension scheme has a “clean” CSA which permits Gilts and cash to be used as collateral, market consensus over the past few years has been that the appropriate valuation rate for your swaps should be the Sterling Overnight Index Average (“Sonia”) which is widely used in the money markets to measure where banks lend GBP cash to one another on an overnight unsecured basis.

Because pension schemes do not maintain large cash balances (as they work their assets as hard as they can), most LDI transactions are collateralised with Gilts, rather than cash, under a clean CSA.  When a bank posts Gilts as collateral, it will source them in the repo market which unlike the unsecured interbank cash market, operates on a collateralised basis and for this reason, repo rates do not track Sonia exactly.  Consensus therefore among market participants is starting to shift again with some banks moving to a valuation discount rate of Sonia plus a spread to reflect the costs of Gilt, not cash, collateral.  In addition to the differences between the unsecured interbank cash market (Sonia) and the collateralised securities lending repo market (repo rate or Sonia +/- a spread), banks are now accounting for new regulatory capital charges that they incur when sourcing Gilt collateral in the repo market and going forward the spread on how your swaps are valued could continue to be driven by ever-changing bank regulation.

The resulting change in how your swaps are valued not only introduces the potential for pricing variability among your dealing counterparties which is precisely what moving to a clean CSA was supposed to remove, but it will also mean that your hedges are not worth as much as you thought they were.  In some cases, the spread applied to the Sonia valuation rate could be as high as 0.10%.  While this may not sound like much, it could equate to a 1-3% cost to your scheme’s funding ratio, depending on the duration and composition of your LDI hedging portfolio.

Bigger picture, this shows that it is possible to protect your scheme against one risk (in this case, lower real interest rates) only to learn later that another risk has been created (in this case, bank regulatory risk) and as a trustee board, the question then becomes whether you are set up to monitor and manage what is essentially a game of Whac-A-Mole.  These dynamics are not unique to your interest rate and inflation hedging and it is not unreasonable to assume that additional regulatory or indeed some yet unknown risk surfaces in other corners of the LDI market, such as in the offshore captive structures that some schemes have used recently to purchase longevity protection.

All of this has important implications as you approach self-sufficiency where your ability to absorb shocks to your scheme funding level reduces substantially.  Given this, self-sufficiency is not simply a matter of being fully funded on a prudent discount rate and having an asset portfolio that generates the cash flows to meet your liabilities.  It also means provisioning for yet unknown risks.  For many schemes, this will mean that being fully funded on a self-sufficient basis of, for example, Gilts +0.50% with provisions for unknown risks as well as future expenses will essentially be equivalent to being fully funded on Gilts flat without provisions and once you are fully funded on this basis, a very valid question to ask is why wouldn’t you just undertake a buyout and be done with it.

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