On 24 April 2023, The Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) each issued guidance for UK defined benefit (DB) pension schemes and their managers on Liability Driven Investment (LDI) strategies: TPR's guidance is here, and the FCA's guidance is here.
The new TPR and FCA guidance follows the volatility crisis in
the UK gilts market in late September 2022 and the statements
issued at the time by the two regulators (see our previous
briefing). The new guidance
is aimed at increasing the resilience of LDI strategies for DB
schemes and sets out the expectations of the regulators in relation
to how DB schemes and their managers (among other stakeholders)
ought to manage the risks inherent in LDI strategies in the long
term.
1 TPR's guidance
The new TPR guidance applies to DB schemes using LDI in pooled funds (i.e. where multiple individual schemes effect their LDI strategy through one fund for a pool of clients) and to segregated LDI strategies for individual schemes.
The new TPR guidance introduces a liquidity buffer threshold for collateral and margin calls, stress-testing requirements, and makes various recommendations to trustees in relation to the governance and ongoing monitoring of pension scheme LDI arrangements.
Whilst TPR guidance is primarily addressed at schemes using leveraged LDI strategies, elements of TPR's guidance may be relevant to non-leveraged LDI strategies and may be applied accordingly.
Reference to schemes in this note should be read to mean DB schemes.
Regulatory LDI buffers
The headline development is the introduction of a regulatory collateral buffer, set at a level determined by the scheme's specific LDI strategy, but subject to a minimum level of resilience to sustain a yield shock of at least 250 bps in addition to an operational buffer required to manage day-to-day yield movement and other risks. This follows the recommendation made to TPR by the Bank of England in its Financial Policy Summary published on 29 March 2023.
TPR now expects scheme trustees to use LDI only to the extent that an appropriate buffer is in place. This buffer should consist of two elements:
- an "operational buffer"; set at a
level determined by the scheme's specific LDI strategy, to
cover day-to-day volatility risk in the markets to which the scheme
is exposed. The operational buffer should be modified to adapt to
the prevailing market environment but TPR expects that it should at
least reflect the volatility of gilt yields in normal market
conditions.
- a "market stress buffer"; which TPR recommends is set at a minimum level of 250 bps over the operational buffer to provide additional liquidity and resilience during severe market stress.
The collateral buffer requirements are cumulative, such that if the operational buffer is set at 100bps and the market stress buffer is set at 250 bps, the total buffer should be 350bps.
Market stress buffer
TPR does not specify which specific market stress conditions the buffer is designed to absorb, though the market stress buffer should be set at a level which allows schemes to operate business as usual during periods of "sharp market movements". TPR notes that the buffer should be replenished if it is utilised or drops too low.
LDI managers will expect calls for cash or assets to replenish the buffer to be met promptly (which TPR has stated should be capable of being done within five business days both in a normal market and in times of market stress), so trustees will need to be cognisant of the impact of stressed market conditions on a scheme's ability to meet such cash or asset calls. If it is likely that it would take longer than five business days to replenish the assets held in the buffer, or if the assets within the buffer are more volatile than the typical composition of an LDI fund, trustees should consider setting a higher market stress buffer. Assets used to meet such calls will need to be sufficiently liquid (even in stressed conditions). Trustees and their advisers should consider the implications of a value reduction of particular asset classes during stressed market conditions as they may no longer be appropriate for the new buffer requirements. A contingency can be agreed in such circumstances.
TPR expects schemes to document their policies for the management and replenishment of the buffer to ensure quick decisions can be made in accordance with an agreed process. For example, trustees should agree in advance who is authorised to sell assets (e.g. the LDI manager, investment platform or a fiduciary manager), whether further instructions from the trustee to managers are needed or whether certain decisions are delegated. Any delegations should be clearly defined and appropriately reflected in legal agreements. Schemes should also have an appropriate number of authorised signatories to avoid absences resulting in delays to asset sales. Schemes may also want to agree whether there should be a "waterfall" of asset sales and how to top-up sold assets, particularly where there may be cumulative cash calls. In such cases, the relevant processes should be clearly documented e.g. in a collateral management policy.
LDI and investment strategy
TPR acknowledges that the introduction of the collateral buffer requires trustees actively to consider the benefits and risks of LDI within the context of the scheme's investment strategy (having regard to, among other factors, (i) the scheme's overall liabilities; (ii) the collateral requirements of LDI arrangements; and (iii) the scheme's asset allocation).
To the extent schemes re-evaluate the use of LDI following the introduction of the regulatory buffer or following the LDI crisis, TPR expects that any changes in investment strategy are well-documented.
Liquidity facilities
In September 2022 we saw several schemes turning to short-term liquidity lines (e.g. from the sponsoring employer) or use of repo facilities (e.g. with a bank) to provide cash for margin calls while gilt yields were very volatile. TPR's guidance allows schemes to make use of such liquidity lines provided the arrangements are clearly documented and subject to regular legal review to ensure that such facilities are available when needed.
Stress testing
TPR requires the scheme's investment adviser or LDI manager to design tests for resilience of the pool of collateral available to support the LDI strategy, while also requiring trustees themselves to understand the risks and satisfy themselves that the resilience testing is sufficient for the scheme. Although the design of the tests is left to the investment adviser or LDI manager, TPR suggests either (i) testing a range of market scenarios that the manager or adviser should take into account and a holistic view of the effect of those scenarios on the LDI arrangements or (ii) determining the size of market movement that would result in the scheme having to replenish the buffer or running out of assets to replenish the buffer. The range of market scenarios to consider should include operational risks such as time taken to make decisions, impact of dealing cycles, impact on the scheme's overall investment portfolio and on hedges and any risk to a scheme's ability to meet obligations to make benefit payments.
TPR suggests these tests should be performed "regularly", although the guidance suggests that annual testing is sufficient unless there are changes to the scheme's funding position or significant market changes.
Governance
The new TPR guidance also sets out TPR's expectations as to how the LDI strategy and processes interact with the investment governance of the scheme. Trustees need to be clear on the lines of responsibility, and the remit of the trustee's role and those of the scheme's advisors. Trustees must ensure that any delegation of management (e.g. to an investment or LDI manager or fiduciary) of the buffer is appropriate to the scheme governance, to ensure that key strategic investment decisions are not delegated, as these must remain with the trustee. Trustees are encouraged to ask their managers to demonstrate compliance with the FCA's good practice and any supervisor of pooled funds in the place of establishment. Trustees should also carefully consider whether it is appropriate to delegate decisions to increase fund allocation to illiquid assets to managers or whether investment management agreements should be (re)negotiated to restrict the flexibility of managers in strategic asset allocation.
Monitoring
Lastly, TPR recommends that schemes have arrangements in place for monitoring the ongoing resilience of their LDI arrangements. Trustees can achieve this by finding out what monitoring the LDI manager itself performs, and ensuring that the trustee receives the necessary information from managers to understand and react to risk. Establishing such arrangements may require the support of advisers (or even the delegation of monitoring to advisers) due to the complexity of LDI, as well as bond and derivative markets. TPR encourages schemes to monitor data on, among other things, (i) the value of LDI assets; (ii) the value and liquidity of assets to meet collateral calls; (iii) the size of the buffer; (iv) the timeline for meeting collateral calls; and (v) the associated impact of reductions in hedging or loss of hedges altogether.
Trustees may wish to amend existing legal and/or operational
agreements with managers to include reporting requirements for
certain events outside the usual manager reporting cycle, which
will be relevant to trustees in times of market stress – e.g.
if the collateral buffer drops below a certain level. Such
arrangements will allow schemes the time to respond appropriately
in the event of extreme market conditions and minimise the risks of
a systemic shock.
2 FCA's guidance and recommendations
The FCA's guidance applies to FCA-authorised firms who manage mandates from pension schemes in relation to LDI strategies. The FCA guidance sets out the FCA's expectations in relation to how LDI managers should address specific risk management deficiencies that became apparent in the wake of the LDI crisis in September 2022. Where the LDI strategy is managed by an alternative investment fund manager (AIFM) established outside the UK, the FCA guidance also applies to UK firms who are appointed as delegated portfolio managers by those AIFMs.
Risk management and stress testing
Like TPR, the FCA states that, whilst LDI managers are responsible for developing their own stress test scenarios, they need to consider broader risks in the value chain in which they operate, such as the delegation of activities (whether to or from the LDI manager) and cross-jurisdictional market risks.
The FCA guidance again aligns with TPR guidance by recommending that LDI managers establish liquidity buffers managed at a level that is able to withstand 'severe but plausible stresses' in the gilts market, meet margin calls and other foreseeable demands in such circumstances.
The FCA encourages and will work with LDI managers to improve their operating practices, by developing stress tests and contingency plans to deal with stress events that take into consideration operational and external events. For example, external events may include an unforeseen change in asset price or liquidity for assets relevant to an LDI strategy. Operational events may include a failure of critical system or supplier or a cyber-attack.
LDI managers are also required to identify and manage the risks inherent in their portfolios in order to mitigate against operational and market vulnerabilities. The FCA lists a number of points that LDI managers should actively consider, including (i) concentration risks; (ii) the composition of their clients' liquidity waterfalls and how they will perform in a stressed scenario; (iii) the extent of leverage at client, fund and firm level and how the leveraged instruments will behave in stressed markets; (iv) the possible speed and extent of macroeconomic shocks; (v) the liquidity of the assets available to draw on and whether those assets are in the firm's control; and (vi) the regulatory and legal consequences of any action they may take.
Conflicts of interest
Conflicts of interest can arise between clients in the same fund, or in different funds, or between LDI and non-LDI clients and with the manager itself. The FCA expects LDI managers to review their approach to such conflicts, including the allocation of resources to particular clients or client groups, and the appropriateness of pooled funds for individual clients (i.e. schemes), who may benefit from more flexibility than can be offered within a pooled fund.
Next steps
The FCA states that firms are expected to make all necessary changes required to implement improvements to their operating practices "as a matter of urgency". Regulated firms have a duty to notify the FCA promptly of developments in their operations which pose a risk of harm to market function or consumers. This includes the risk of firms being unable to meet their obligations to counterparties, or where systemic risks arise which could disrupt the normal functioning of the markets.
The operational issues the FCA encourages LDI managers to address are similar to those highlighted by TPR's guidance. Trustees should collaborate with managers in order to ensure that the collateral and liquidity requirements of an LDI strategy are sufficiently robust and should seek assurances that managers are complying with the FCA's risk management recommendations. This is an opportune moment for trustees of DB schemes to discuss and formalise appropriate operational and communication arrangements with managers to ensure that the LDI strategy supports the scheme's investment objectives and mitigates against foreseeable and (to the extent possible) unforeseeable market risks.
Originally published 22 May 2023
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