UK’s largest pension scheme was warned against debt strategy before crisis

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The UK’s largest private-sector pension scheme increased its exposure to debt-fuelled investment strategies earlier this year in spite of warnings the move would bring “significant risks”.

The £90bn Universities Superannuation Scheme ploughed more of its members’ assets into leveraged hedging, the strategy that was engulfed by crisis last week after a surge in government bond yields prompted an emergency intervention by the Bank of England.

The proposal was spearheaded by USS chief executive Bill Galvin, who prior to joining the plan was head of The Pensions Regulator.

Several of the scheme’s highest-profile sponsoring employers, including Cambridge and Oxford universities and Imperial College London, had opposed the move after it was proposed in February out of concern that a greater reliance on leverage could lead to a fire sale of assets in volatile markets.

“We believe the increase in leverage may introduce potentially significant risks into the scheme in a period of high market volatility,” wrote Cambridge, Oxford and Imperial College in a letter to Galvin in February.

The warnings proved prescient when gilt yields soared last week, forcing many pension schemes that use so-called liability driven investing strategies to sell assets to raise cash to meet collateral calls.

The USS said it was not a “forced” seller of any assets through the gilt market turmoil, which was triggered by Chancellor Kwasi Kwarteng’s unfunded tax cut announcement of September 23, but it had “taken actions to rebalance its portfolio exposures”.

“While navigating market conditions was challenging — in terms of the speed of response required — it was manageable,” said USS, adding that it had received broad support for its proposals.

The USS proposed to increase its investment appetite for LDI from 35 per cent to 52 per cent of its portfolio, with leverage more than doubling from 17 per cent to 37 per cent of weighted assets, according to a consultation letter sent in February.

USS told the Financial Times it was unable to provide current levels of leverage or LDI, as these changed on a near-daily basis. However, in a March 2022 implementation update, leverage was 27 per cent of the portfolio weight, and LDI 34.8 per cent.

LDI is a risk management tool used by schemes to secure pensions from adverse movements in interest rates and to ensure that funding levels do not deteriorate when rates fall. Some schemes use leveraged LDI, or short-term debt, to funds purchase of further growth assets.

At the height of the gilt crisis last week, thousands of defined benefit pension plans with LDI strategies faced a liquidity crunch due to emergency collateral calls on these contracts as government bond yields spiralled.

USS noted that “from a funding perspective, interest rate rises are having a positive impact”. However, it added that the volatility in the UK market, “clearly driven” by recent government announcements, made it “very difficult to establish a long-term view”.

Renewed scrutiny of USS’s investment strategy, particularly its increased use of leverage, comes as regulators face calls to more strictly supervise the use of leverage by pension funds.

The Pensions Regulator does not currently record in-depth data on the scale of collateral or leverage agreed to by defined benefit schemes, nor does it ask every scheme to provide this data.

Bernard Casey, a retired academic and founder of Social Economic Research, a think-tank, said: “Pension funds using leverage are acting like shadow banks which themselves are insufficiently regulated. What we have seen over the past few weeks is the chickens coming home to roost on LDI.”

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