LDI crisis: Never again?

The House of Commons Work and Pensions Committee (WPC) issued its report “Defined benefit pensions with Liability Driven Investments” (the Report)¹ on 23 June 2023. This sets out the WPC’s feedback and recommendations following its call for evidence on the LDI² crisis that unfolded last year.

The fundamental point within the Report is summarised by the following statement:

“DB pension scheme investments must not be allowed to jeopardise the UK economy again.”

While we are likely to see a more a nuanced view develop over the next few months – indeed, over the next few days with the Chancellor of the Exchequer’s Mansion House speech taking place on 10 July – it is already clear that trustees should get ready for change.

Whether you agree with the above statement from the Report or not (we certainly feel this stance casts undue blame on the pensions industry), it raises three questions:

• What are the implications for trustees?
• Who or what was to blame?
• Never again?

What are the implications for trustees?

While the Report runs to more than fifty pages, it does clearly set out the dynamics behind the LDI crisis, including the roles and responsibilities of most of the key protagonists. The Report provides a useful summary in the opening pages as well as a handy “Conclusions and recommendations” section. The main elements of the Report and its recommendations relate to feedback and actions for the DWP³, TPR³ and the FCA³. However, from a trustee perspective, key points to note are:

• Expect to provide more data to TPR going forward on the use of LDI and engage with TPR accordingly. In particular, the DWP and TPR have been asked to consult on whether to introduce disclosure requirements for pension schemes on their use of LDI.
• The suggested disclosure requirements include the maximum leverage allowed in LDI funds; the type of LDI and compliance with minimum resilience levels.
• The DWP has been asked to consider whether the use of LDI could be restricted, for example, based on a test related to a trustee boards’ ability to understand and manage the risks involved.
• The WPC raised questions around governance, including whether there should be a requirement for some form of qualification for at least some trustees.
• A recommendation that the Government bring forward plans for investment consultants to be brought within the FCA’s regulatory perimeter before the end of this Parliament.
• The DWP and TPR should halt their existing plans for a new funding regime, at least until they have produced a full impact assessment for the proposals. This was driven by two concerns. The first being that the proposals may not allow open schemes to thrive and the second that it could result in greater “herding” in investment decisions.

The disclosure requirements should be easily addressed if implemented, whilst the proposal regarding investment consultants is interesting given that advice on selecting or purchasing financial products (including pooled LDI funds) already falls under FCA regulation. The other proposals may only have limited impact for reasons commented upon below.

Who or what was to blame?

The Report does not hold back in setting out where and with whom it believes the shortcomings lie. Notably, the Report states:

“The regulatory framework was complex and fragmentary, and not fit for purpose when it came to managing systemic risks.”   

Opportunities were missed to set the industry on a firmer footing, with the Report referring to a review of the risks associated with leverage conducted by the Bank of England in 2018 and a subsequent survey undertaken by TPR in 2019. The Report notes that the work done focused on large schemes whereas it was the pooled LDI funds in which smaller schemes tend to invest that came under particular pressure.

However, this relates to the operational aspects of LDI which were stretched to levels well beyond what had previously been envisaged due to the market’s reaction to the UK Government’s September 2022 “mini-budget”. This was a good old-fashioned crisis of confidence in a sovereign. Pension funds were victims in this, not the aggressors. The responsibility of the Government to understand the implications of its actions is missing from the Report.

The fact that the regulatory framework was complex did not help. However, in our opinion, the root cause of the problem goes back to the regulation itself. Indeed, the Report notes:

“Those who were more critical said that making pension funds sensitive to movements in gilt markets, combined with the cautious approach TPR had taken to scheme funding, had contributed to the closure of DB schemes.”

Over the last 30 years or so, legislation and regulation materially changed the nature of DB schemes. While these changes have been made with the best intentions, they have had unintended detrimental consequences (not least the closure of DB schemes). The increasing plethora of short-term metrics used to assess the health of a scheme with a long-term strategy caused a real dilemma. LDI was the solution.

The proposed actions will, we believe, treat the symptoms but not the cause unless there is a fundamental change in legislation and regulatory regime.

Closing the stable door

From an investment perspective, the practical effect of the proposals may be limited. With gilt yields now approaching the heights reached during the LDI crisis last autumn, it provides an opportunity for many schemes to de-risk and/or reduce leverage and thereby mitigate the impact of the WPC’s proposals.

We do, however, need to recognise that not all schemes will be in such a fortunate position. It is important, therefore, to consider any unintended consequences of the WPC recommendations and the actions already taken by regulators.

There is a fine balance in setting risk controls. Too lax and problems can arise quite easily; too stringent and innovative ideas never get off the ground. It is easy to say, with the benefit of hindsight, that leverage levels within some LDI funds were too high. However, do we now have the right balance? There is an irony that leverage levels have been reduced after yields have risen so much. The next scandal could arise due to a sharp fall in gilt yields. Whilst this would not be expected to jeopardise the UK economy it could cause a material decline in the funding level of schemes unable to achieve their desired level of hedging due to increased LDI capital requirements.

Never again?

Having created a framework that has resulted in a massive shift out of equities into bonds, it is interesting that questions are now being raised over the merits of this, just as many UK pension schemes are approaching a place where they can sail quietly into the sunset. Indeed, the Chancellor of the Exchequer is due to outline his plans during this month’s Mansion House speech.

It will be interesting to see what the Chancellor has to say in his Mansion House speech given recent market dynamics which have brought de-risking opportunities. This means a shrinking asset base and time horizon to see meaningful results for any growth-oriented proposals.

The extent to which the Chancellor’s proposals reduce marginal demand for gilts within DB pension schemes will need to be considered carefully. Given the quantitative tightening being undertaken by the Bank of England and the DMO’s³ program of gilt issuance, both of which increase supply, care needs to be taken that the proposals, if implemented, do not spark a second LDI crisis!

We will be keeping a keen eye on any proposals coming out of the Chancellor’s Mansion House speech and responses from TPR on the DB funding code.

Notes:

1. Contains Parliamentary information licensed under the Open Parliament Licence 3.0
2. LDI refers to Liability Driven Investment and unless otherwise indicated relates to leveraged LDI
3. DWP – Department for Work and Pensions; TPR – The Pensions Regulator; FCA – Financial Conduct Authority; DMO – Debt Management Office