LDI Collateral Call and the Eroded Hedge
A UK defined benefit pension scheme has liabilities of £1.4bn on a gilts-plus basis and assets of £1.15bn, a funding ratio of 82%. The sponsor is a mid-sized manufacturer with a weak covenant and no appetite for further deficit contributions. The trustees operate a de-risking glidepath that triggers at 95% funding. Interest rate and inflation risk are 55% hedged through a pooled leveraged LDI fund geared at 2.8x, backed by a £45m segregated gilt collateral pool. Last quarter, 30-year gilt yields rose 120bp. The LDI manager issued a £28m collateral call, which was met by selling the gilt pool, and the hedge ratio has fallen to 48%. At the same time the return-seeking portfolio, comprising global equities and private credit, fell 9%. The scheme actuary estimates that a further 100bp rise in yields would require another £35m of collateral, which the scheme does not currently hold in eligible form. The trustee board meets in two weeks; the sponsor has offered a one-off £20m contribution.
1. Evaluate the options available to the trustees to restore the hedge ratio and strengthen the collateral position, and recommend a course of action.
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The core problem is that the hedge has fallen to 48% just when the scheme's funding position is most sensitive to a fall in yields, and the collateral buffer is exhausted. The options are:
- Top up collateral by selling return-seeking assets. This preserves the hedge but crystallises a 9% loss at the worst point and permanently reduces the expected return needed to close the deficit. It is only defensible if the trustees hold a view that yields will rise further, which is a market view the scheme should not take.
- Reduce LDI notional to match available collateral. This deliberately lowers the hedge (perhaps to 40%) and removes forced-selling risk, but leaves the scheme structurally under-hedged. If yields fall 100bp, liabilities rise more than assets and the deficit widens with no offset.
- Use the sponsor's £20m. This is the cheapest short-term collateral and should be accepted, but it is one-off and moves funding only to about 83%. It should be ring-fenced as collateral, not spent.
- Change the structure. Move to a lower-geared or segregated LDI mandate, or a physical bond portfolio, so that the same hedge requires less collateral. This costs expected return but is more robust.
Recommendation: accept the £20m, reduce leverage modestly to a level where collateral covers a 200bp move, and rebuild a buffer before restoring the hedge. The hedge ratio is a risk control, not a return target, and should not be rebuilt by selling equities into a drawdown unless the growth portfolio can be maintained.
2. Explain how the glidepath should be applied given the fall in the hedge ratio, and whether the sponsor's £20m offer changes your recommendation.
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The glidepath trigger is a funding-level rule (95%) and is not triggered at 82%, so it does not by itself compel action. But the glidepath was designed as a one-way de-risking mechanism and implicitly assumes the hedge ratio is maintained. The fall to 48% is a failure of the collateral policy, not of the glidepath. The trustees should:
- separate the funding trigger from a hedge-ratio and collateral trigger, adding explicit triggers such as a hedge ratio below 50% or collateral cover below 150bp;
- delegate authority to an investment sub-committee to act within days, because two weeks is too slow in a collateral crisis;
- recognise that the £20m moves funding to about 83.5%, still far from 95%, so it does not change the strategic position; it is a liquidity injection, not a de-risking event;
- question whether the gilts-plus funding measure overstates the improvement from the yield rise relative to a buyout or solvency basis, which is the measure that matters to the sponsor and the Pensions Regulator.
The glidepath should not be suspended. It should be supplemented so that a collateral event cannot silently undo the hedge. The £20m changes the liquidity recommendation (accept it, ring-fence it) but not the strategic one: the scheme remains under-hedged relative to its risk appetite and needs a structural fix, not a one-off contribution.