Experts warn DWP rules could lead more schemes to LDI

During a panel discussion at the Pensions and Lifetime Savings Association annual conference in Liverpool on October 13, Railpen head of funding analysis Martin Hunter questioned whether the new rules, “which are expected to bring more prescription” to the DB sector, will lead more schemes to the same risks the industry is seeing with LDI.

“Are we moving into an even riskier world in the future with that direction of travel?” he asked.

NatWest Group director for reward and employment Carol Young noted that she shared some of Hunter’s concerns, as “the sponsor of some schemes that are very well funded and have some carefully thought out and heavily negotiated plans to get to an endgame”.

One-size-fits-all, low-dependency targets could crowd out investment in infrastructure and other secure income asset classes, concentrating investments – and the associated risks – in gilts and credit that target very low returns

Rash Bhabra, Willis Towers Watson

“Then trying to lay on top of that some of the potential prescription [set out in the consultation ...], that might constrain some actions that we might otherwise take, so I’m sure that will be brought to life in the consultation discussions,” she said.

“I also think it is inevitable that if we were to put in place as it is described, it would certainly involve — with as many schemes closed as they are — everyone crowding around a particular type of funding; it would look a lot more like risk reduction and a lot of hedging.

“And given what we've seen about the sustained impact pension scheme hedging appears to be able to have on the broader economy, I’ve no doubt that [we will mention it in the responses to the consultation].”

The central bank announced on September 28 a £65bn bond-buying programme in an attempt to stabilise markets, after falling government bond prices prompted collateral calls for DB schemes.

LDI is a risk management tool used to protect schemes from adverse movements in interest rates and ensuring that funding levels do not deteriorate when interest rates fall.

Pension funds will have plans in place so that if interest rates rise, they are required to post collateral, and schemes and managers typically conduct a stress test against a 1 per cent rise in long-term gilt yields.

While schemes have generally coped with the additional capital calls required, an increase in gilt yields to 4 per cent went beyond the contingency plans that most schemes had in place, creating stress within the financial system and dictating the need for the BoE intervention.

DWP’s new DB rules met with criticism

The Department for Work and Pensions published its consultation into DB funding on July 26, following the introduction of the Pension Schemes Act 2021, which set out the framework for the government’s proposals on this topic.

For schemes at or past significant maturity, the proposed rules state that these are expected to be funded on a low-dependency basis by the time they reach significant maturity.

Pension funds must also have a low-risk investment allocation, with sufficient cash flow matching, and must provide a good degree of matching against short-term adverse movements in market conditions.

The draft regulations also require that information on expected categories of investment be included in a statement of strategy to be agreed by the employer.

Rash Bhabra, head of retirement for Great Britain at Willis Towers Watson, has called for the rules to be reconsidered.

“In other policy areas, the government has shelved proposals that it inherited. These pension funding regulations should also be sent back to the drawing board,” he said.

Bhabra pointed out that “prioritising enforceability above all else has meant inserting too much prescription into what was supposed to be a principles-based framework”.

He argued that “there is little flexibility around the ‘low dependency’ positions that schemes must target, nor around how quickly they must get there”. 

“One-size-fits-all, low-dependency targets could crowd out investment in infrastructure and other secure income asset classes, concentrating investments — and the associated risks — in gilts and credit that target very low returns.”

Association of Consulting Actuaries chair Steven Taylor also believes that, given recent financial market developments, the “opportunity should now be taken to reflect on the broad dynamics laid out in the draft regulations that drive schemes towards very cautious investment approaches as they mature, to ensure these will not contribute to increased systemic risks when viewed across the whole industry”.

The DWP rules will be followed by the Pensions Regulator’s DB funding code, which is expected to come into force in 2023.

In a letter to the Work and Pensions Committee about the recent market turmoil, TPR’s chief executive, Charles Counsell, said: “It is important to state that the DB funding system gives trustees discretion and flexibility over the way they invest to deliver on their pension promises and manage risks, and we expect this to continue.

“Our new funding code will guide schemes to take less risk as they mature and particularly beyond the point of high maturity. It will also provide us with greater opportunity to intervene where the level of risk is not supported by the employer covenant.”