Defined benefit pensions with Liability Driven Investments – Report Summary

Summary

Liability Driven Investment (LDI) has been in use for about twenty years as a tool which defined benefit (DB) pension schemes use for managing volatility in their funding levels. It involves investing in assets whose value moves in the same direction as that of their liabilities. The intention is to reduce volatility in the scheme’s funding level, giving employers greater predictability about the level of their contributions.

For pension schemes in deficit (where the value of assets is less than the liabilities), using leveraged LDI enables them to do this in a more capital efficient way, allowing them also to invest in return seeking assets to reduce their deficits over time. However, leveraged LDI funds need to post collateral as security to the bank counterparties. Increases in gilt yields can give rise to the demand for additional collateral to be posted.

LDI played a role in helping schemes to improve their funding level when interest rates were low and scheme deficits high. However, we are concerned that this was funded by leverage (borrowing), the inherent risks of which did not get sufficient attention until a crisis hit. This happened in September 2022, due to the economic turbulence which followed the ‘mini-Budget’, when sharp rises in gilt yields, unprecedented in their speed and scale, resulted in LDI funds being required to post additional collateral at short notice. To meet collateral calls, and reduce leverage, LDI funds had to rebalance by selling liquid assets or asking their DB pension scheme investors to provide more collateral. When this rebalancing could not be achieved quickly enough, LDI funds were forced to sell gilts into an illiquid market. This risked reinforcing the downward pressure on gilt prices, creating a downward spiral which the Bank of England had to intervene to stop.

The Bank’s intervention allowed LDI funds to rebalance and rebuild their resilience to manage future moves in the market. The Pensions Regulator (TPR) said in April 2023 that most pension schemes had improved funding levels through a combination of investment performance and a significant rise in gilt yields (which has the effect of reducing the present value of liabilities). However, for a minority, funding levels fell due to the market disruption and such schemes may face challenges in restoring their position, for example, because of the costs of the measures to improve resilience in LDI funds, or because of the way in which their asset allocation has been disrupted. External analysis raises questions as to how confident we can be about these improvements in funding levels. As part of ensuring the right lessons are learned from the LDI episode, we think that the Department for Work and Pensions (DWP) and TPR should look at how many pension schemes lost out, by how much and what role LDI strategies played in this.

DB scheme regulation

There are two lines of defence to enable pension schemes to manage risk: firstly, the trustees, who are responsible for investment decisions; secondly, The Pensions Regulator (TPR) with its statutory objective to improve the way workplace pension schemes are run. The events of September 2022 revealed significant weaknesses in both lines of defence.

TPR has had concerns about governance standards, particularly in small and medium sized schemes, for some years. In 2016, for example, it noted that challenges included investment decisions and engaging with advisers. Following the events of September, TPR’s then Chief Executive, Charles Counsell, told us it was a “fair question…about the degree to which smaller schemes really understood the implications of the investments they were taking.” He also acknowledged that the information currently being collected on LDI was “not sufficiently detailed” for it to assess whether its guidance is being followed across pension schemes. Given this, we think TPR should have focused earlier on the risks of encouraging schemes to use such complex financial products.

The Financial Policy Committee (FPC) recommended that TPR: i) specify the minimum levels of resilience for LDI arrangements in which pension schemes invest; and ii) work with other regulators, to ensure that LDI funds maintain the resilience that has been built up. We recommend that, DWP and TPR explain how they intend to deliver on these recommendations. The challenge to doing so is that TPR can issue guidance but still has no means to check the extent to which it is being followed across DB schemes.

A consistent theme of this Report is that more systematic, regular and comprehensive collection of data on LDI is needed. We recommend that TPR should consider requiring trustees to report regularly on their use of LDI and that it should develop a strategy for engaging more closely with schemes based on the results. More broadly, we welcome TPR’s commitment to become a more digitally enabled and data-led organisation. The events of September 2022 demonstrate the importance of driving this forward. We recommend that DWP and TPR report back to us on a timeline and plans to resource it.

Another consistent theme is the need to improve governance throughout the investment chain. Asked about plans to improve governance standards in pension schemes, TPR said that scheme consolidation will bring economies of scale but that consolidation needed to be into a safe vehicle, which would need a statutory framework. DWP consulted on DB consolidation in 2018. As a first step to improving governance, we recommend that it publishes its response to this consultation by the end of October 2023. It should then work with TPR as a priority to improve the regulation of trustees and standards of governance, as it has said it intends to do. Given the time it will take to consult on, legislate for, and implement measures to improve governance, DWP should 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 ability of pension scheme trustees to ensure they get good advice was cited as an area of weakness. We heard, including from the Financial Conduct Authority (FCA), that in some cases investment consultants were giving standardised advice, rather than thinking through what is best for the pension fund. We recommend that the Government bring forward plans for investment consultants to be brought within the FCA’s regulatory perimeter.

Managing systemic risk

We question whether TPR had understood the ‘doom loop’ risks inherent in LDI products. In 2018, the Bank of England assessed the risks associated with leverage, noting that it could expose non-banks (including pension schemes) to “sudden demands for high-quality collateral, which could result in forced sales of potentially illiquid assets.” It identified the need “for more comprehensive and consistent monitoring by authorities…to keep this under review.” Following this, TPR conducted a survey in 2019.

The work done at this time was a missed opportunity in two respects. Firstly, it focused on large schemes and the conclusion was that they had arrangements in place to manage the risk. In fact, in September 2022, it was the pooled LDI funds, in which small pension schemes were invested, which came under particular pressure. The second missed opportunity was that no system for collecting data on LDI from pension schemes was put in place after the survey. As a result, the use of leverage grew in a way that was not visible to the regulators until the crisis hit in September. Given the concentration of DB schemes’ investments in the gilts market, more should have been done to follow up on the problem identified in 2018. The reason this did not happen appears to be gaps in the arrangements for managing systemic risk.

In March 2023, the Bank of England’s Financial Policy Committee (FPC) recommended that TPR should have the remit to take account of financial stability considerations on a continuing basis. We tend to agree, although it depends what it means. One option would be for TPR to be a key source of information on DB scheme investments, able to identify potential risks proactively in the workplace pensions sector, but working with other regulators to analyse the implications.

The LDI episode has also raised wider questions about how pension scheme funding works and whether the way liabilities are calculated is always appropriate. DWP and TPR are proposing to introduce a new funding regime in April 2024. We have two concerns about this. Firstly, we are not convinced there is sufficient flexibility to enable open pension schemes to thrive. This is an issue we will return to in our wider inquiry into defined benefit pension schemes. Secondly, there is a risk of increased ‘herding’ in pension scheme investments, with even more pension schemes being encouraged to act in the same way. In light of the FPC’s recommendation for TPR to take account of financial stability, 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, including the impact on financial stability and on open DB schemes.