REVIEW OF FINANCIAL MARKETS
PLUGGING THE REGULATORY GAPS TO KEEP PENSIONS SAFER IN FUTURE CRISES
IN FEBRUARY 2023, THE HOUSE OF LORDS INDUSTRY AND REGULATORS COMMITTEE CRITICISED THE USE OF LIABILITY-DRIVEN INVESTMENT (LDI) STRATEGIES BY DEFINED BENEFIT PENSION FUNDS, RAISING CONCERNS THAT REGULATORS HAD NOT FOCUSED SUFFICIENTLY ON THE RISKS AND DANGERS THAT BORROWING TO BOOST INVESTMENT RETURNS COULD POSE TO PENSION SCHEME FINANCES, AND TO WIDER FINANCIAL STABILITY IN THE EVENT OF INTEREST RATES RISING
Key findings from the committee’s scrutiny, during which it heard from industry and regulatory representatives, including Legal & General, the Financial Conduct Authority, The Pensions Regulator, and pensions experts, included:*
• LDI investment strategies, particularly those that use leverage, were created as a solution to an artificial problem created by accounting standards, which drive sponsoring companies to focus heavily on current, rather than long-term, estimates of pension deficits. Pension schemes aimed to hedge volatility in these estimates by investing in bonds, but due to the low returns these offered and the need to close their deficits, they borrowed to boost their returns.
• The use of borrowing and derivatives for these purposes is not permitted by the relevant underlying EU legislation, which appears to have been permissively transposed in the UK to allow pension schemes to continue using such strategies.
• It is likely some pension scheme trustees were not aware of the potential implications of their LDI strategies and their decision-making struggled to match the pace of markets. This has led them to become dependent on advice from investment consultants, whose advice to schemes is currently unregulated and may not be comprehensive over the whole portfolio or cover operational requirements.
• Despite calls for more information and a review of stress tests from the Financial Policy Committee, regulators in the sector appear to have been slow to recognise the systemic risks caused by the concentration of pension schemes’ ownership of assets such as index-linked gilts, and the increasing use of more complex, bank-like strategies and instruments by
pension funds.
THE RECOMMENDATIONS The Lords committee calls for action to improve regulation and
CISI.ORG/REVIEW
reduce the risk of similar disruption in the future. It recommends that:
• UK government and the Endorsement Board should review whether the current system of accounting for pension scheme finances in company accounts is appropriate and whether to introduce a system that does not drive short-termism in pensions investment. More schemes should be allowed to take an asset-based approach if this is appropriate for them.
• The government should review the relevant regulations and consider whether the use of repos and derivatives should be more tightly controlled and supervised in future. If schemes are to continue to use leveraged LDI, there should be far stricter limits and reporting on the amount of leverage allowed in LDI funds.
• The government should ensure that investment consultants are brought within the regulatory perimeter as a matter of urgency. Following this, regulators must have heed to the non-professional nature of trustees in their regulation of consultants and ensure consultants are liable for their advice. Regulators should ensure they have more information on the leverage present within pension scheme finances and that stress tests are conducted. The government should consider giving the Prudential Regulation Authority a role in overseeing pension schemes.
• The Pensions Regulator should be given a statutory duty or ministerial direction to consider the impacts of the pensions sector on the wider financial system. The Financial Policy Committee should continue to take the lead on systemic risks to financial stability and should be given the power to direct action by regulators in the pensions sector if they fail to take sufficient action to address risks.
The use of leverage and derivatives is key to considerations of the risks posed by LDI. The Pensions Regulator published a survey on DB pension scheme leverage and liquidity in 2019 which found that 45% of all schemes
had increased their use of leverage over the past five years, accounting for 58% of scheme assets. The notional principal of schemes’ leveraged investments totalled almost £500bn. The survey set out that the level of leverage ranged from 1x to 7x. Critics of LDI suggest that LDI funds, and particularly pooled funds which involve several small and medium-sized pension schemes, tend towards the higher end of that leverage, making them unstable and requiring only relatively small declines in price or yield to require high degrees of leverage to be unwound.
Lord Hollick, chair of the Industry and Regulators Committee, said:
The evidence we heard overwhelmingly suggests that the use of LDI strategies caused the Bank of England intervention. If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction, rather than a downward spiral in government debt markets that threatened the UK’s financial stability and led to significant losses as pension fund assets had to be sold in order to meet LDI liquidity requirements.
The impacts of accounting standards and the widespread adoption of leveraged LDI have transformed pension schemes from being long-term institutions into ones focused mainly on short-term volatility in prices and interest rates.
We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes. This will help ensure that the turbulence that followed the September 2022
fiscal statement doesn’t happen again.
*Source: UK Parliament Committee report, ‘Leveraged LDI strategies worsened September 2022 financial turmoil’
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