New guidelines aimed at avoiding a repeat of last September’s liability-driven investment (LDI) crisis have been set out today by the UK’s regulator for the pension schemes that use the products as well as the body supervising asset managers that offer them.
The advice on LDI follows Bank of England (BoE) recommendations published at the end of March aimed at regulators on how much liquidity defined benefit pension funds should be earmarking to service their LDI funds in case of sudden rises in interest rates – such as those seen in September 2022.
Lou Davey, The Pensions Regulator’s (TPR) interim director of regulatory policy, analysis and advice, said: “The unprecedented market volatility seen last September clearly demonstrated there is the need for stronger buffers, more stringent governance and operational processes and more oversight by trustees.
“Trustees must understand the risks they carry in their investment strategy, and only use leveraged LDI if appropriate,” she said.
The new TPR guidance on LDI, which replaces its October 2022 LDI statement as well as its guidance from November 2022, provided practical steps to ensure trustees achieved this vital balance, Davey said, adding that the regulator expected trustees to use it.
TPR said its new guidance set out specific steps trustees should take when investing in LDI, looking at where LDI fits within a scheme’s investment strategy; setting, operating and maintaining a collateral buffer; testing for resilience; ensuring schemes had the right governance and operational processes in place, and monitoring LDI.
Trustees should only invest in leveraged LDI arrangements which had an “appropriately sized buffer” in place, TPR said.
“This must include an operational buffer specific to the LDI arrangement to manage day-to-day changes, in addition to the 250 basis points minimum to provide resilience in times of market stress,” it said.
Meanwhile, the Financial Conduct Authority (FCA), today published its own recommendations for asset managers on LDI.
Sarah Pritchard, executive director, markets at the FCA, said: “This guidance sets out what we expect in terms of risk management, stress testing and client communication, so that the necessary lessons are learned from last September’s extreme events.”
“Since September last year, we have been closely monitoring asset managers using LDI strategies as they make improvements and the sector is now much more resilient to potential risks, but there is more to be done,” she said.
In its guidance, the FCA details how liquidity buffers should be set for each sub-fund, also referring to BoE publications which describe how buffer levels might be constructed to deal with systemic and idiosyncratic shocks.
However, the FCA said liquidity management measures such as fund liquidity buffers were only part of the solution to address vulnerabilities.
“Strengthening the resilience of LDI strategies requires realistic contingency planning and the application of appropriately designed stress tests,” it said.
The FCA pointed out that because of the way the LDI market was structured, various different regulators were involved in its supervision.
The FCA is responsible for the authorisation and regulation of UK-based fund managers, which are typically responsible for executing investment strategies for assets delegated to them by the product manufacturer – firms which are usually non-UK domiciled alternative investment fund managers.
Commenting on today’s coordinated statements from the FCA and TPR on LDI, consultancy XPS Pensions Group said neither included specific regulatory change, but that both “set out a clear direction of how this market needs to evolve to meet their expectations”.
Simeon Willis, chief investment officer at XPS Pension Group, said: “A theme running through the FCA announcement was one of all participants sharing greater responsibility for LDI arrangements being appropriate to achieve the end investor’s intended outcome.”
A higher bar was being set, he said.
“It’s clear that a siloed approach from investment manager or investment adviser, narrowly focused on their own role alone, is insufficient to meet expectations,” said Willis.
Sinead Leahy, managing director at Cardano, added: “Overall, the system and use of LDI is not broken and what we saw at the end of last year was an extreme event that was not foreseen by the market. However, there have definitely been winners and losers. And so, it is important that trustees and sponsors effectively run a ‘healthcheck’ on their mandate.”
She noted that the new TPR guidance regarding collateral buffers will mean that some pension schemes will need to review their returns objectives and level of hedging, as it won’t be possible to continue hedging to the same degree and target high returns and meet the new collateral guidance.
“Choices will need to be made. Unfortunately, you can’t have your cake and eat it. As both the FCA and TPR guidance say, the focus should not just be on collateral management and governance but also look at the operational side of the overall LDI mandate – how is the process managed, monitored and acted upon,” Leahy said.
Joe Dabrowski, deputy director – policy, at the Pensions and Lifetime Savings Association (PLSA), agreed that it was it is prudent of TPR to publish guidance on how to manage the potential risks, which were exposed by the unprecedented volatility episode that followed the UK’s mini-Budget last autumn.
However, he said the PLSA would like to see further detail from regulators on how they will continue to assess systemic risks into the future.
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