Lords call for ‘far stricter limits’ on LDI leverage

The peers have also supported calls for investment consultants to fall within the Financial Conduct Authority remit, while asking the government to review repurchase agreements and derivatives regulations.

In a letter to City minister Andrew Griffith and pensions minister Laura Trott, the House of Lords’ Industry and Regulators Committee criticised the use of leveraged LDI strategies by defined benefit schemes.

Committee chair Lord Hollick said: “The evidence we heard overwhelmingly suggests that the use of LDI strategies caused the Bank of England intervention.

We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies

Lord Hollick

“If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction, rather than a downward spiral in government debt markets that threatened the UK’s financial stability and led to significant losses, as pension fund assets had to be sold in order to meet LDI liquidity requirements.”

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.

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.

Several pensions experts have told parliamentary inquiries that leveraged LDI was the main cause of this crisis, with some calling for this feature to be banned.

It is common for schemes to introduce leverage into their LDI portfolios to free up capital to invest in growth assets, and in the case of an interest rate rise – where liabilities and asset values fall – this leverage will increase.

As a result, the LDI fund manager will require additional capital to reduce the leverage to the original level.

Accounting standards at the root of the problem

The Lords letter detailed how LDI strategies, particularly those with leverage, were created in response to “an artificial problem created by accounting standards”, which require a measure of the current value of scheme assets against a ‘present value’ of future pension liabilities, discounted at a low-risk market interest rate.

This has driven “sponsoring companies to focus heavily on current, rather than long-term, estimates of pension deficits”, it stated.

In turn, “pension schemes aimed to hedge volatility in these estimates by investing in bonds, but due to the low returns these offered and the need to close their deficits, they borrowed to boost their returns”, the letter continued.

The peers are therefore recommending a review of the current accounting system by the government and the UK Endorsement Board, to ensure it is appropriate, and “whether to introduce a system that does not drive short-termism in pensions investment”.

The committee’s findings also highlighted that EU legislation, which does not permit the use of borrowing and derivatives for leveraged LDI purposes, “appears to have been permissively transposed in a way that allows pension schemes to continue using such strategies”.

Due to this, the peers called on the government to review “the relevant regulations and consider whether the use of repos and derivatives should be more tightly controlled and supervised in future”.

If schemes are to continue to use leveraged LDI, “there should be far stricter limits and reporting on the amount of leverage allowed in LDI funds”, the Lords argued, noting that these changes should be included in the draft funding regulations published by the Department for Work and Pensions in 2022 and in the Pensions Regulator’s DB funding code.

The committee also supported the introduction of greater liquidity buffers “for any leveraged exposures to avoid collateral calls leading to cascading loops in markets”.

TPR published guidance for schemes in November, setting out the expectation that liquidity buffers be maintained across pooled and leveraged LDI mandates.

Sterling-denominated LDI funds across Europe are expected to secure 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 from which an LDI fund is insulated, 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.

However, “given the instability caused by even small price movements in the index-linked gilt market”, the peers argued that buffers cannot be the only answer, and must be “accompanied by a reduction in leverage and in the concentration of ownership of certain types of bonds” by DB schemes.

Hollick said: “The impacts of accounting standards and the widespread adoption of leveraged LDI have transformed pension schemes from being long-term institutions into ones focused mainly on short-term volatility in prices and interest rates.

“We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes.

“This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again.”

Bring schemes into PRA’s remit

Despite hearing evidence that the market turbulence in October could not have been foreseen, the committee stated that it “should not be a surprise to financial regulators, firms or pension schemes that financial markets can move quickly and create unforeseen risks, especially where hidden pockets of leverage exist”.

The Lords noted that these systemic risks are more likely to be found in the pensions sector now that it is using “more complex, bank-like strategies and instruments, including leverage and derivatives”.

They argued that “the more bank-like a pension scheme’s strategy is, the more bank-like its regulation and supervision should be”, suggesting that it could be a role for the PRA to oversee pension schemes, especially given the increasing likelihood of schemes being bought out by insurers.

“The government should review whether the PRA should be given joint or direct supervisory responsibility of pension funds using bank-like strategies and instruments,” the letter stated.

The committee also recommended that TPR “should closely supervise stress-testing by at least a sample of DB pension funds, or carry out its own stress test, to ensure it is on top of systemic risks in the sector”, rather than providing guidance for schemes to carry out these tests.

If TPR is unable to do this, it should request that the FCA, the PRA or the Bank of England carry out these tests on its behalf, it noted.

Last, but not least, the Lords supported the request from the FCA for investment consultants to be regulated.

These companies “play a key role” in determining the investment strategies of schemes and, given the predominance of LDI in those strategies, it is “clear that consultants helped to drive schemes towards adopting LDI”, the letter stated.

The peers argued “it is problematic that they are not fully regulated as part of the regulatory perimeter, especially in relation to their advice to schemes on their investment strategies, for which they should not be able to disclaim liability”.

Due to this, the committee has called for the government to ensure that investment consultants are brought within the regulatory perimeter “as a matter of urgency”.

“Once this is done, regulators must have heed to the non-professional nature of trustees in their regulation of consultants and ensure consultants are liable for their advice.”