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Will the pension fund crisis lead to lawsuits?

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(ES Compost)

An awkward question is currently being asked around city offices: “Does this all feel a little 2008-y to you?” It’s easy to see why the current economic turmoil mirrors the prelude to the 2008 financial crisis: Sudden changes in market conditions are beginning to reveal problems with previously safe investment strategies.

All this comes after a decade of unusual economic conditions; Investors with incredibly low interest rates, lots of liquidity and lots of capital are demanding more and more risk returns. Many companies are not yet well positioned for changes in market conditions and may expose themselves to unwanted risks that they can no longer pass on to counterparties.

A cautionary tale can be seen in the recent pension fund crisis surrounding Liability Driven Investment (LDI) strategies. LDI strategies are largely executed by or for pension funds to manage their exposure to inflation and interest rate risk. Pension funds, especially defined benefit plans, must ensure that there is no shortage of funds over the long term for the fund to pay out to its beneficiaries. Therefore, they must generate returns that keep pace with inflation and interest rates. While pension funds have traditionally used bonds to hedge this exposure, LDI strategies use derivatives to do the same.

However, government bond yields rose sharply on September 23, 2022 due to the quasi Kwarteng mini budget shock. Pension funds had to increase assets in LDI strategies to maintain the same risk. But the growth was so rapid that many couldn’t fund it with liquid assets, leading to a sell-off of illiquid assets they wouldn’t normally want to get rid of. As widely reported, this has prompted the Bank of England to buy up UK government bonds to stabilize the market and reduce the need for funds to sell assets.

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LDI strategies are not necessarily bad. Properly implemented, they are a sensible way of hedging risk, and only come under pressure in extreme market conditions. And so we see an echo of the questions that were asked in the aftermath of the financial crisis: do pension fund managers understand the risks? Did he get bad advice? Was there adequate governance and regulation to prevent reckless risk-taking? Will this lead to a lawsuit? The answer will depend on the specific circumstances, but in general the exposure would be higher if the funds were more leveraged. Making a quick U-turn and reducing their LDI holdings is not really an option for pension managers, as companies will be forced to funnel money into pension plans at a time when corporate finances are already under strain.

So what does this panic in the retirement disco tell us about what risks everyone in the C-suite and everyone who manages investment strategies at night should be taking? The clash of a sustained period of both financial and geopolitical volatility simultaneously means that all bets are off. Risk management strategies should be regularly reviewed and updated to adapt to market conditions. After weeks of chaos under the truce, things have stabilized somewhat with Sunak and Hunt, and interest rates are no longer expected to rise as much as previously expected. But recent events show that boards, trustees and advisors must be nimble to keep up with the new normal, or expose themselves to a real risk of loss and ensuing litigation.

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