Bigger LDI collateral buffers will increase sponsor reliance, MPs told

The committee heard from professional trustees and investment experts on December 7 in the latest stage of its inquiry into liability-driven investments, which is taking place in the aftermath of autumn’s pension scheme liquidity crisis.

It was told in a November session that around £500bn in pension scheme assets are “missing somewhere” as a result of the autumn turmoil.

The more you shore up in collateral, the less you’re investing in growth

Kerrin Rosenberg, Cardano Investment

A trade-off between safety and returns

In November, the Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier – known together as the national competent authorities – noted an improvement in the resilience of sterling-denominated LDI funds across Europe, with an average yield buffer of around 300bp to 400bp having been secured. 

This buffer refers to the level of yield adjustment on long-term gilts that an LDI fund is insulated from, or may absorb, before its capital reserves are depleted. LDI funds trading in the UK are based exclusively in the Republic of Ireland and Luxembourg.

Before the September “mini” Budget, which was followed by a spike in gilt yields and ensuing collateral calls for schemes, 48 per cent of schemes had capital buffers below 200bp to 249bp, according to the Pensions and Lifetime Savings Association.

Just one in five schemes had buffers of more than 300bp. In early October, more than half said they planned to increase their collateral buffer to more than 300bp by October 14, while a 10th intended to make their buffer 250bp.

The NCAs and the Pensions Regulator have said that they expect improved buffers to be maintained, with TPR setting this expectation for both pooled and segregated leveraged LDI mandates.

“There is a trade off between how safe one makes the collateral buffer and what return one can earn on the growth assets,” Cardano Investment chief executive Kerrin Rosenberg told the committee.

“The more you shore up in collateral, the less you’re investing in growth.”

‘Some pension funds will have to go back to the drawing board’

The actions of trustees, their advisers and regulators have all come under question during the committee’s inquiry, as well as the use of leveraged LDI, with some experts having called for its use by schemes to be banned.

Rosenberg, appearing alongside Insight Investment CEO Abdallah Nauphal and Schroders Investment Management CEO Charles Prideaux – both of whose companies offer LDIs – responded to questions over the future make-up of collateral.

Nauphal said that Insight previously had concerns about collateral being held in cash, claiming that this could create liquidity problems. 

“This is one of the reasons we fought very hard against forcing pension schemes to clear all their swaps, because the collateral is in cash,” he said.

Keeping collateral in broader forms, including gilts and high-quality corporate problems, would help solve liquidity issues, Nauphal said.

“Regulation today, or at least bank regulation, [does] not make it easy to use non-cash or non-gilt as collateral, but it would go a long way to solving the liquidity challenges,” he continued. Prideaux echoed this sentiment.

The requirement for LDI managers to have higher tolerance for rate rises is there, but that’s only part of the infrastructure

David Fogarty, Dalriada Trustees

Rosenberg warned that increased buffers would force revisions to investment approaches.

“At 400bp, at 4 per cent, there will be some pension funds that will have to go back to the drawing board,” Rosenberg said.

He added that these funds “will have to reappraise their strategies. At 4 per cent-type buffer levels they may have to pare back their growth ambitions and that will have consequences on the amount of money their sponsors will have to put in”.

Rosenberg said that the most extreme scenario – where no leverage is allowed, with an “unlimited buffer” – would probably cost the industry around £30bn to £40bn a year in extra sponsor contributions.

Association of Professional Pension Trustees chair Harus Rai told the committee in an earlier session that day that testing scenarios for buffers of 300 to 400bp were welcome, “but it is a large amount”, he warned.

“We need to now understand what sort of effect that will have on pension schemes in terms of where they can invest elsewhere.”

Regulators called upon to set minimum standards

During autumn’s volatility, TPR issued guidance urging schemes to “review their liquidity, liability hedging and governance processes, suggesting that managers of their LDIs could be granted power of attorney over some assets to quicken trading”.

TPR CEO Charles Counsell told the Industry and Regulators Committee in November that there had been varying levels of understanding of LDI among trustees, while Financial Conduct Authority CEO Nikhil Rathi suggested “gaps in competence” for some investors to the same committee.

The Work and Pensions Committee is examining the role of regulation in the crisis and the ways it could be revised.

“I don’t think regulation should aim to protect the system against a complete lack of confidence in the gilt market. I think that is too big an ask,” Rosenberg said.

TPR could be asked to create some parameters to ensure that leverage is used sensibly, he suggested.

Nauphal, meanwhile, said that it would be useful for regulation to clarify “minimum standards”, pointing out that Insight was operating a buffer of almost 2 per cent, claiming that this sat above a general industry standard of 1 per cent.

“There is an economic cost for me to have a higher economic buffer because it’s cheaper to use someone who has a lesser buffer,” he said.

While LDI funds have on average become more resilient, owing to enlarged buffers, Dalriada Trustees director David Fogarty warned that if the autumn crisis were to repeat itself today, “there’d be nearly as much of a problem”.

“The requirement for LDI managers to have higher tolerance for rate rises is there, but that’s only part of the infrastructure,” he said.

“Schemes haven’t actually had the time, post-crisis, to review their strategy. They haven’t had time to reconsider their hedging level and whether that’s the one they really like. 

“They haven’t had the time to consider the impact on the rest of their assets. And they haven’t time to reconsider whether they have the right skills to take all of those decisions, and whether they should do more to strengthen the board,” Fogarty continued.

“Hopefully, in a matter of probably three to six months – and it is more like that, rather than weeks – many of those things will have been gone through, and they will be better prepared at that point.”