Pensions Regulator issues statement on LDI

The Pensions Regulator has issued a statement in which it sets out the actions trustees of defined benefit (DB) and defined contribution (DC) schemes should consider before the end of the Bank of England's gilt purchase scheme and in the near-term as they navigate continued market volatility. The actions trustees of DB schemes might need to take depend on whether they currently hedge against interest rate movements and, if they do, whether this is through a segregated mandate or a pooled fund. DC trustees are urged to review their investment strategy and communicate with savers who may be concerned about the impact of market conditions on their savings.

Key actions

The key actions identified by the Regulator for DB trustees with interest rate hedging in place include:

• reviewing their current liquidity position with their advisers, including understanding their sources of liquidity, reviewing any liquidity waterfalls and topping up or increasing collateral where appropriate
• considering whether they have sufficient liquidity to meet future collateral calls in a more volatile environment
• reviewing the extent of their liability hedging and any changes to the degree of leverage within their LDI fund
• reviewing their scheme's funding position (which in most cases is likely to have improved), as they may be approaching funding triggers put in place for action and considering the impact on the scheme's longer-term funding objectives as trustees may find themselves ahead of their target or expected position
• reviewing the balance of risk in their scheme’s investment portfolio and considering the need to rebalance their risk profile, and
• reviewing the appropriateness of the assumptions used in calculating transfer values (as these are impacted by changes in gilt yields) and being alert to the opportunities for scams created by market volatility and following best practice in this area.

In some cases, schemes might also want to discuss with their employer the potential for them to provide additional collateral where the scheme is unable to create enough liquidity from the scheme assets. Trustees could discuss whether their employer is able and willing to accelerate future contributions or provide liquidity by other means (such as by way of a short-term loan). Employers may consider that taking such action to maintain a hedged position against interest rate and inflation risks is in their interests, to reduce the likelihood of having to make higher deficit repair contributions in the future if liabilities increase.

Schemes that do not currently hedge will potentially have seen significant improvements in funding levels over the last few weeks. The Regulator points out that these schemes may wish to consider whether they review their asset allocation or their decision to hedge in light of recent movements. Trustees of such schemes will need to consider whether the funding position might improve further if yields increase or whether they might face a reduction in their current funding position if yields fall. Trustees should also consider the ability of the covenant to support investment risk, recognising that current market events might also have impacted covenant strength.

Reviewing operational processes

The Regulator points out that recent events have shown how important it is that trustees are able to act quickly when needed. It reminds trustees that they should have robust procedures in place to enable them to respond to changing circumstances, make decisions and implement them where the need arises. As part of this, it says consideration should be given to whether adding one or more professional trustees would help in these circumstances.

Trustees should ensure that they can implement and adapt their liquidity and cash management plans quickly and that there are contingency plans in place to respond to changing market conditions. To achieve this, trustees may need to review the governance processes in place to buy and sell investments, and the decision-making requirements. For example, the REgulator points out that granting LDI managers power of attorney over some scheme assets is a way to enable swifter trading.

Defending LDI

The statement defends the use of LDI strategies by DB schemes, pointing out that the use of leveraged LDI has helped many DB pension schemes manage the risks to their funding position over the past 20 years and contributed to an improvement in funding for many DB schemes over that period. It has also helped to manage the affordability of DB schemes for employers.

The statement also points out that many DB pension schemes have experienced improvements in their funding positions during 2022 as a result of the increases in long-term gilt yields.

The Regulator says that risk to LDI strategies associated with gilt yields rising was well understood by trustees, advisers and LDI managers. Such risks are mitigated by keeping aside a proportion of liquid assets, which can then be sold to raise cash that can be posted as collateral. However, it says that it was the "unprecedented speed and magnitude at which gilt yields increased towards the end of September, as well as the ability of schemes and LDI funds to respond to this, that created liquidity pressures as LDI managers urgently sought further collateral". The Regulator makes clear that DB pension schemes were not at risk of “collapse” due to the rapid movements in gilt yields, rather "the key challenge for schemes has been the ability to access liquidity at short notice to maintain their liability hedging positions in an environment when long-term interest rates rose rapidly in just a few days".

It points out that "A DB scheme that cannot meet demands for more collateral, or was invested in an LDI fund that did not meet its collateral requirements or reduced leverage in order to maintain its position, may lose some of its hedging protection. This would mean its funding level is less well protected against a fall in bond yields in the future". However, this does not jeopardise the solvency of the scheme.

Next steps

If you would like to discuss how recent market conditions are impacting your scheme or organisation and the actions you should be taking in response to this, please speak to your usual HSF adviser or contact one of our specialists:

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