Fall-out from last Autumn’s LDI crisis culminates in new Pensions Regulator LDI Guidance

The Regulator has published its detailed Funding and Investment Guidance, Using leveraged liability-driven investment. Cast to provide practical steps for scheme trustees using “leveraged liability-driven investment” (LDI), the Guidance (which pushes trustees to actively monitor their scheme’s LDI exposure) will also be of interest to employers, investment managers and funds alike. 

The Regulator defines LDI as being where trustees use financial instruments to increase their allocation in certain assets (such as gilts, index-linked gilts and fixed income derivatives) and those financial instruments require the trustees to provide collateral to counterparties as security. 

Use of LDI is not banned under the Guidance but trustees are expected to ensure that any investment risks they are taking are consistent with the funding profile of their scheme and the support available from their employer. As a part of fulfilling their trustee knowledge and understanding requirements, trustees must ensure they are familiar with how LDI works and the associated risks when using it. Implementing a programme of trustee training, which is repeated for any new trustees, is a practical step trustees can take to ensure they have the knowledge and resources to make informed decisions and be able to act quickly should the need arise. 

Trustees need to be able to explain in their investment strategies how they can provide collateral for LDI held by their schemes if required and how long it would take them to provide that collateral. 

Increased oversight from the Regulator is to be expected, as too is trustee engagement with sponsors and investment advisers.

1. Trustees will be expected to ensure that their controls and governance around LDI remain appropriate. Governance processes will need to be implemented or refined to ensure that trustees can monitor their LDI resilience and their advisers monitoring of the same. The ability to act quickly in stressed situations is a critical consideration. Trustees who meet infrequently, have infrequent contact with advisers and high levels of leverage need to be especially confident they can act quickly and effectively in a crisis. Practical considerations which trustees may want to think about to ensure they can respond urgently to any crisis:
   • schemes that use delegated investment sub-committees may set a good example: decisions in relation to LDI could also be delegated in advance to a small number of trustees (even within an investment sub-committee) so that trustees can convene and respond quickly; and
   • trustees may also want to work with their advisers to ensure they have a clear strategy for what practical steps need to be taken in a crisis, including in relation to the flow of relevant information. Trustees should consider the nature, format and frequency of the reports that they receive from their investment managers to ensure that when called to make urgent decisions, trustees are doing so relying on the most relevant information. 
2. Some schemes will need to review their illiquid investments against their exposure to LDI collateral calls. To determine how LDI fits within their investment strategy, trustees should have regard to:
   • scheme liabilities and any desirable mitigation from movements in gilt yields on liabilities;
   • expected scheme payments (including benefit payments) relative to the expected income from investments or contributions. Trustees should be confident they can meet their payment obligations, including when LDI arrangements are under stress;
   • their expectations for return on scheme investments and tolerable levels of risk to achieve that return;
   • any LDI collateral and cash call requirements and the ability to meet any such call, considering the availability and liquidity of other scheme assets held;
   • the strategic asset allocation of their scheme and any assets that might increase LDI risks: illiquid assets that cannot readily be sold or used to meet collateral calls; and
   • the sensitivity of other assets to market movements which might result in collateral calls separate to LDI.
3. Schemes using LDI should have a buffer in place that consists only of assets that can be reliably sourced or converted to collateral in a timely manner:
   • operational buffer: should have sufficient liquidity to manage day to day market volatility
   • market stress buffer: sufficiently liquidity to provide resilience during severe market stress. Set at a minimum level of 250 basis points with sufficient cash or assets to replenish the buffer within five days. Can be drawn on in periods of stress but should otherwise be maintained at minimum levels.
4. Considerations over the appropriate size of the buffer, and speed at which the trustees can react to cash calls to replenish the buffer if it drops too low, may lead to more external arrangements with sponsors (such as lines of credit or escrows) which ensure that schemes are able to meet their investment return targets without holding excess cash or frustrating their ability to invest in more growth illiquid assets. Trustees may want to have conversations with their sponsors now to understand the extent to which they could provide a line of credit having regard to any wider obligations or commitments those sponsors may have. Sponsors themselves may need to speak to their advisers to ensure that any line of credit provided (or promised) is acceptable having regards to the terms of their refinancing arrangements, for example. 

The Guidance will sit alongside changes to the DB funding regime when it comes into force. The Regulator has recently indicated that the draft Funding and Investment Strategy Amendment Regulations and its draft DB Funding Code of Practice (which we recently covered in a separate article), originally expected in force in the Autumn, are not expected to come into force until April 2024.