News Alert 2023/03

At a glance

The Pensions Regulator has issued important new guidance for DB pension scheme trustees who use leveraged liability driven investment strategies.  It replaces guidance issued in the latter part of 2022 following turbulence in the gilt market.

Key Actions

Trustees

• Work with your investment advisers and LDI manager to ensure that you are compliant with the Pensions Regulator’s new expectations.

Scheme sponsors

• Check that the trustees are considering this guidance to ensure that the scheme's LDI arrangements and wider investment strategy remain robust.

The Detail

On 24 April 2023 the Pensions Regulator issued new guidance setting out the steps DB pension scheme trustees should take to manage risks when using leveraged liability driven investments (LDI).  The Regulator’s guidance follows the Bank of England’s statement on 29 March 2023 (see Pensions Bulletin 2023/14) which in effect directed the Regulator to set minimum levels of resilience for LDI funds and LDI mandates used by DB trustees.  The guidance also replaces the Regulator’s 12 October 2022 statement on the then market conditions (see Pensions Bulletin 2022/37) and its 30 November 2022 LDI guidance (see Pensions Bulletin 2022/44), both of which have been removed from the Regulator’s website.

On the same day as the Regulator issued its new guidance, the Financial Conduct Authority issued its own guidance for LDI managers.  This sets out recommendations to address specific vulnerabilities that arose within LDI managers, based on the FCA’s oversight of markets and firms during and after September 2022’s volatility and intelligence from other market participants and other regulatory authorities in the UK and internationally.  The letters issued on 30 November 2022 by the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier of Luxembourg remain in force for the pooled LDI funds they regulate.

In this News Alert we look at the Pensions Regulator’s new guidance which is in four parts, only one of which is as a direct result of the Bank of England’s request.  The guidance is intended as a comprehensive statement of the Regulator’s expectations of trustees who are or are considering using leveraged LDI.

Investment strategy

After some scene setting and introductory remarks the guidance first deals with investment strategy where it asks trustees to consider the benefits and risks of LDI within the wider context of the scheme, pointing out the potential tension between using LDI to manage funding volatility and having to maintain a certain level of liquidity to meet collateral calls when interest rates change.

A number of points are set out for consideration when determining where LDI fits within the trustees’ investment strategy, including the collateral and cash call requirements of LDI arrangements and the availability and liquidity of assets or other arrangements that can be used to meet such cash calls.  There is also an expectation that any changes to the scheme’s investment strategy are documented with some specific matters being recorded, including how collateral for LDI would be provided if needed and how long it would take.  There is a reminder that before investing, trustees must obtain and consider written investment advice, which for an LDI proposal should cover its suitability, the benefits and risks of the investment and the recommended operational processes to make the investment work.

Our viewpoint

This part of the guidance provides a useful recap of what trustees should be doing already as part of considering whether or not to have an LDI exposure.  There is nothing particularly new or controversial here.

Collateral resilience

The guidance then goes on consider the need for the LDI arrangements invested in to be resilient to short-term adverse changes in market conditions.  The concept of an asset buffer is introduced, which can be drawn on by the LDI fund manager if additional collateral is called for as a result of changing market conditions.

Turning to the issue that the Bank of England asked the Pensions Regulator to address, the Regulator asks trustees to think in terms of holding a “market stress buffer”, ie additional liquidity to provide resilience during severe market stress, that can be called on to cover an adverse change in gilt yields of at least 250 basis points.  A smaller “operational buffer” should also be held to cover day-to-day gilt yield volatility in normal market conditions.  Taken together these buffers should ensure that the LDI arrangements can withstand large but “plausible” moves in the gilt markets as well as re-capitalise themselves in ways that don’t further contribute to market stress.

The Regulator states that these buffers are cumulative – if an arrangement’s operational buffer is set at 100 basis points and the market stress buffer at 250 then the total buffer will be 350.

For pooled funds, LDI managers will define the operational buffer themselves and trustees will need to satisfy themselves that this is sufficient.  For segregated arrangements trustees will define the operational buffer alongside advisers and managers.

The guidance does not specify exactly what kind of assets should form the buffers but encourages trustees to focus on the liquidation timescales of assets, particularly a standard of five days.  Only assets that can reliably be sourced or converted to eligible collateral in a timely manner should be held in the buffer.  The Regulator asks trustees to consider how their processes for replenishment of the buffers will work should there be a quick succession of cash calls, but there is no suggestion that buffers need immediate replenishment.

The guidance then moves on to consider how trustees should carry out resilience (or “stress”) testing, supported by their advisers and managers.  It suggests that such testing can be done in one of two ways – through examining different scenarios that are relevant to the investment strategy and its vulnerabilities, and through looking at the size of market movement required before a specific event would happen – such as a call to replenish the buffer, and before assets earmarked for buffer replenishment are exhausted.  The outcome of the tests decided upon should be recorded and any areas of concern addressed.

The Regulator expects the resilience tests to be done regularly, such as annually or triennially, but also when there are significant changes in funding, investment or market conditions.

Our viewpoint

This section of the guidance gives a sufficient steer to trustees to assist them in addressing this important issue, whilst leaving it firmly with investment advisers or LDI managers to design the necessary tests.  Interestingly, the Regulator has not sought to have any reporting of these tests at this stage, but we understand that it is considering how best to construct a reporting regime.

We welcome the clarity that the LDI collateral buffers are able to be drawn upon in periods of market stress.  We had seen some interpretations that buffers need to be maintained at all times, which would have simply moved the problem of the potential for forced selling, rather than fix it.  This clarity may now give the required confidence for LDI managers to re-leverage their funds by returning money to clients when yields fall.

Governance

The guidance next turns to the need for trustees to understand the role and responsibilities of the various parties to the trustees’ LDI arrangement (such as investment advisers, investment or fiduciary managers and LDI managers).  Examples of roles are listed.

These roles need to be appropriate to how the scheme operates, it should be clear what service each party is providing, the processes that must be followed (and any discretion or limitations), with these services being appropriately reflected in legal agreements and contracts.  Assurance should be sought that all parties have the required capacity to operate in stressed market conditions, and that action can be taken promptly as required.  Trustees may wish to ask their LDI manager what steps they have taken to meet the FCA’s guidance, and, in relation to any pooled funds, how they meet the guidance put out by the Irish and Luxembourg authorities.

The appropriateness of the LDI governance arrangements and operational processes should be reviewed periodically.

Our viewpoint

All of this makes sense.  Trustees need to have a sufficiently full enough understanding of how the various parties to their LDI arrangements work along with confidence that their processes will stand up in times of stress.

Monitoring

Finally, the Regulator turns to the importance of monitoring the resilience of the LDI arrangements that have been set up.  Trustees need to understand what monitoring their advisers or the LDI managers perform routinely and put in place mechanisms to ensure that necessary and sufficient information is received by the trustees so that they can understand and be able to react to risks.

The guidance goes on to set out some examples of data that may be useful in monitoring LDI resilience – in effect various metrics of the LDI arrangement.  The Regulator leaves it to trustees to decide the frequency of such regular reporting.  Separately, it suggests that trustees may want to ask for certain information to be provided outside the normal reporting cycle if certain triggers are met, for example when the buffer drops beneath a certain level or by a certain amount - and to have information more frequently and promptly in extreme market conditions.

Our viewpoint

Once again the Regulator is choosing to provide hints and pointers, leaving it to trustees to work out what is best in their circumstances.  But these examples and suggestions may later form the basis of some more formal reporting to the Regulator.

To conclude

This is a well-balanced piece of guidance that sets out a clear framework within which trustees can operate, whilst leaving much of the detail to be decided at scheme level.  With the benefit of hindsight, it is the sort of guidance that the Regulator should have issued many years ago.  It is unlikely to be the last word – for example, Parliament’s Work and Pensions Committee has yet to set out its findings on the LDI issue and the Government will have its say at some point.

On collateral resilience the LDI market had already adjusted to the much larger buffers than were typical prior to September 2022, ever since the Irish and Luxembourg authorities specified in their 30 November 2022 letters a target buffer level of 300-400 basis points.  This has led to larger allocations to LDI being required to maintain high hedge levels than what was typical prior to 2022.

Our experience is that the majority of LDI arrangements will already be running in a way which is compliant with the Regulator’s new guidance, so we don’t expect it to necessitate short term changes in many cases.  However, it is fair to say that this is not a homogenous marketplace and variation remains between the reporting standards and operational practices of different LDI managers.  This and the FCA’s guidance underscores the need for all LDI managers to move toward best practice.