On 24th April 2023, The Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) released industry guidance on LDI1 resilience. Whilst we are supportive of these recommendations, we note that many trustees may have already reduced their reliance on LDI due to funding level improvements resulting from the rise in yields throughout 2023. For others, the proposed changes will introduce additional governance requirements, and potentially prompt changes to investment strategy.
TPR’s new guidance sets out specific steps trustees should be taking when investing in LDI, looking at:
- Where LDI fits within a scheme’s investment strategy
- Setting, operating and maintaining a collateral buffer
- Testing for resilience
- Making sure schemes have the right governance and operational processes in place
- Monitoring LDI
The underlying driving force behind the guidance is the recommendations issued by the Bank of England (BoE) Financial Policy Committee (FPC) during March 2023. Their focus is on maintaining financial stability and, in particular, avoiding a doom-loop akin to that which started to unfold last autumn until the BoE stepped in.
What is required?
The recent guidance from the FCA is primarily directed to LDI managers, whilst that from the TPR is towards trustees. The message for all parties, however, is that simply increasing the collateral buffers to mitigate the risks associated with a sharp rise in yields is not enough. Rather, this needs to be supported by robust resilience testing that needs to be revisited as circumstances change.
Investment strategy implications Source: The Pensions Regulator
Following last year’s events, clients should be reviewing their investment strategy to ensure that it remains appropriate. Whilst total asset values will have fallen for many schemes due to rising yields, liability values are likely to have fallen to a greater degree, leading to improved funding levels. Therefore, whilst LDI is now less capital efficient due to reduced leverage, the need for leverage may have also reduced.
When reviewing the investment strategy it is important to consider the role that LDI will play going forward. In particular, what is being hedged and why? Are you, for example, aiming to mitigate the volatility in the Technical Provisions funding level or the monetary deficit? Alternatively, you may be looking to hedge the estimated buy-out liabilities at some future point in time. These considerations can lead to very different hedging strategies with materially different levels of leverage. These are important considerations given the reduced efficiency of LDI at a time of heightened economic and market uncertainty.
Solving a quandary
For those schemes requiring an allocation to growth assets to achieve their required returns, the reduced efficiency of LDI creates an apparent challenge. Namely, reduce the growth allocation (with a consequent change to the journey plan and/or schedule of contributions) or reduce the level of liability hedging. These dynamics can, however, be mitigated. This can be achieved by restructuring asset portfolios so that growth assets are held to cover liabilities further into the future, with shorter dated bonds meeting the early years cash flows. In doing this, the growth assets are expected to be held for longer than under more traditional structures. This means you need to hold less of them today, though you may have more in growth assets in the longer term than would otherwise have been the case. This then frees up capital to facilitate the liability hedging program.
These dynamics highlight the importance of considering not only the initial strategic allocation but how it is expected to evolve over time – a point highlighted in the draft DB funding code issued by the Pensions Regulator on 16th December 20222. We call this approach to investment strategy, Cashflow Centred Investment (CCI).
Evolving your governance arrangements
Pension schemes should be reviewing their collateral buffer and liquidity waterfall requirements, ensuring these align with the new requirements. These should be reviewed on a regular basis. We wait to hear from the LDI managers of any changes in their protocols following the FCA guidance, particularly around the five-day cash call period. For schemes that hold assets other than cash within their collateral waterfall, it is important that trustees assess the suitability of such assets and how their value might change in volatile markets. We recommend that trustees have in place written agreed protocols so that if cash is required, this can be arranged at short notice without materially impacting the longer term journey plan.
All these dynamics should be captured within ongoing LDI monitoring. In particular, not only should LDI monitoring review the operational aspects, such as how many cash calls could be covered by the monies held within the liquidity ladder, but also the suitability of the liability hedges as the scheme matures and the market hedging dynamics change. Alongside this, as the situation evolves, it is important to regulary revisit the resilience tests.
Conclusion
In conclusion, pension schemes have seen a fundamental shift over the last twelve months, not only in terms of the economic and market environment but also, for many, their financial health. Whenever such changes occur it is important to consider not only whether the investment strategy remains appropriate, but to also review the governance arranagements in place. The requirements set out by the FCA and TPR are a key part of this.
| 1 | All references to LDI relate to leveraged LDI unless otherwise indicated. |
| 2 | Source: The Pensions Regulator draft DB funding code of practice, paragraph 38: “When determining the journey plan as part of the funding and investment strategy, trustees must consider how they intend to transition from their current investment strategy to a strategy which would meet the standards of a low dependency investment allocation.” |
Important Notice: This article is for Professional investors only and was written as at 26th April 2023. The article is a financial promotion, generic in nature and should not be regarded as providing advice or a recommendation of suitability. No action should be taken without seeking appropriate advice, taking account of relevant developments since the date of this article. There can be no guarantee that the opinions expressed in this document will prove correct.