The Pensions Regulator (TPR) has issued guidance for the UK market on liability-driven investment (LDI) resilience. This comes following the recent turbulence in longer-dated UK government debt (i.e. debt which matures in 12 months or more) in late September which exposed shortcomings in the resilience of LDI funds and the operational processes of the funds and pension schemes investing in them (see our blog post on the market volatility here).
In particular, the ability to raise liquidity in a timely manner was highlighted as an issue for several schemes. As well as creating wider impacts on the orderly functioning of the economy, this created risks for pension schemes of losing the effectiveness of their hedge during a period of high volatility. In response to the volatility, LDI investment managers adopted and implemented higher levels of buffers against yield rises than has been typical in the past.
TPR’s LDI resilience guidance now re-affirms the need to maintain these higher levels of buffers against yield rises, referring to the statement by the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier on resilience of LDI funds published on 30 November 2022. Given that the guidance is in line with what we have already seen a large number of LDI investment managers adopt and implement since early October, the vast majority of schemes are unlikely to need to make immediate changes to investment strategies in order to fit with TPR’s new expectations.
However, with the new regulatory expectations confirmed, schemes can now plan their future investment strategies with more confidence. This could have the effect of creating greater risk and/or imposing increased costs on the sponsoring employers of some schemes, who could be exposed to the possibility of a decrease in scheme protection against movement of interest rates and a reduction in expectations on future investment performance.
TPR’s guidance also aims to improve operational governance of pension schemes as it relates to LDI. The guidance focuses on the operational processes that schemes should have in place around leveraged LDI, along with the stress testing and contingency planning they should undertake. We welcome this focus and believe the processes, testing and planning to be at least as important as the level of leverage itself.
A quick word on buyouts
Rising gilt yields are generally good news for most pension schemes – as gilt yields rise, the value of pension liabilities falls. The value of the scheme’s assets also usually falls in a rising rate environment, but typically by less than the liabilities. So, as a result of the same financial conditions that led to liquidity challenges relating to LDI, many schemes are better funded than they have ever been before and many are now fully funded on a buyout basis. They therefore have the funds to be able to pass their risk to an insurance company, improving protection for members.
It is a positive development to see TPR working together with regulatory authorities from Ireland and Luxembourg on this announcement. Given the outplay of systemic risk at the end of September and during October, we are of the view that a regulatory line in the sand in this area is helpful, to avoid a creeping up of leverage levels over time as LDI managers compete to get the highest returns from their investments. The Work and Pensions Commons Select Committee and the Industry and Regulators Lords Select Committee continue to make enquiries into LDI and we can expect further recommendations, guidance and regulations in this area in the coming months.