The government actuary has called on the Pensions Regulator to start collecting more data from defined benefit schemes about their liability-driven investments, among other suggestions to increase the visibility of risks associated with these strategies.
In a letter to the Work and Pensions Committee, after being invited to contribute to the MPs inquiry into DB schemes with LDI, Martin Clarke explained that within the “UK pensions landscape, the pursuit of similar investment strategies by a significant proportion of otherwise independent pension schemes can create the sort of conditions where systemic risks arise”.
Following the so-called “mini” Budget on September 23, falling government bond prices prompted a series of collateral calls from DB schemes, which some feared would lead to a 'doom loop' that would crash the market.
Issues arose specifically around pension funds’ LDI strategies, designed to protect against falling interest rates. Most schemes had conducted stress tests for a scenario in which there was a 1 per cent rise in long-term gilt yields, but the 4 per cent increase exceeded the contingency plans in place.
Improved availability of data on LDI should help trustees appropriately challenge their advisers and LDI managers
Martin Clarke, Government Actuary Department
The Bank of England announced a £65bn bond-buying programme in September in an attempt to stabilise markets.
The collateral calls led, in some cases, to the fire sale of assets by DB schemes, or trustees entering into emergency arrangements to secure funds to enable them to meet these calls. In other cases, hedge ratios were reduced to avoid contracts terminating.
In November, the WPC was told that around £500bn in assets were “missing” following the crisis, while the Pension Protection Fund warned that the true extent of the turmoil was still unknown.
Clarke noted the liquidity crisis felt by schemes “was exacerbated by governance and operational bottlenecks within parts of the system, particularly in relation to pooled funds”.
According to BoE governor Andrew Bailey, there are around 175 LDI pooled funds operating in the UK market, in which 1,800 pension schemes invest.
More data collection needed
In his letter, dated December 14 and published on January 12, Clarke argued that one of the lessons to be learnt from the liquidity crisis could be “to increase the visibility to all stakeholders of the operational and governance risks associated with strategies such as leveraged LDI and especially those associated with pooled funds”.
He noted that TPR has the power to collect information from schemes, and therefore can “obtain good aggregate and specific data on the use of critical investment strategies such as leveraged LDI”.
He recalled a survey conducted by TPR on the matter in 2019, noting that “a more systematic, regular and comprehensive collection of data on such strategies, and the collateral and operational risk management approaches adopted by schemes of all sizes, may now be considered appropriate”.
“Having such information to assess the scale and range of exposure, assists in engaging across the regulatory space to form mitigation strategies,” Clarke said.
He also said that “consideration may also be given to requiring schemes to perform and report on the results of investment stress tests”, while proposing an increase in the information disclosure by trustees about “their governance and management of investment and associated operational risks in, for example, the annual report of the scheme or the statement of strategy”.
Requirements such as the latter “can be very effective ‘nudges’ to further embed good practice”, Clarke added.
He also pointed out that “improved availability of data on LDI should help trustees appropriately challenge their advisers and LDI managers”, while allowing them “to make judgements on the potential benefits of using LDI relative to the complexity and risks it can introduce”.
Caution is necessary
On the whole, Clarke cautioned against an “overreaction or the introduction of overly restrictive regulations”.
He noted that many schemes that use LDI did weather the storm “as they were well prepared”.
“A number of mitigations have already been voluntarily introduced from various stakeholders and the wide coverage of this issue is expected to have provoked users of LDI to challenge their investment strategies and governance processes,” he argued.
DB schemes mull legal action against LDI asset managers
Defined benefit schemes that suffered losses as a result of the recent market volatility are considering bringing claims against their asset managers and advisers, legal experts have warned.
TPR published guidance on this matter on November 30, setting out its expectation that liquidity buffers be maintained across pooled and leveraged LDI mandates.
Sterling-denominated LDI funds across Europe have secured an average yield buffer of around 300 basis points to 400bp, according to the Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier.
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.
