LIBOR – the London Interbank Offered Rate – is due to be discontinued at the end of 2021. LIBOR is used in many financial contracts as a benchmark interest rate and is intended to represent the average rate at which banks can obtain unsecured finance in the London Interbank Market. In pension scheme investment, it is most commonly used in liability-driven investments, derivative contracts and longevity contracts.
The LIBOR rigging scandal and a decline in the use of the interbank market has meant that LIBOR is no longer seen as a sustainable benchmark, with concerns that the rate does not have a long-term future because it is not based on a sufficient volume of actual wholesale transactions. In response to these concerns, the administrator of LIBOR has consulted on ceasing to publish the benchmark at the end of 2021 and the Financial Conduct Authority (FCA) and other regulators are encouraging market participants to transition to using alternative risk-free reference rates prior to LIBOR's discontinuance. For Sterling-denominated contracts, the principal replacement rate will be the Sterling Overnight Index Average (SONIA). Typically, SONIA will be lower than LIBOR, as it does not include a risk premium element.
What should pensions scheme trustees do?
LIBOR is embedded into many financial contracts, for example interest rate swaps, longevity contracts and some pooled fund arrangements. Investment guidelines in investment management agreements may also reference LIBOR. Trustees should speak with their investment managers to ascertain the number of contracts that may be affected by LIBOR cessation and the managers' plans to transition contracts to replacement rates (principally SONIA). Trustees should require investment managers to ensure any transition to risk-free reference rates such as SONIA does not result in economic detriment to the pension scheme. Specialist legal advice may be needed, particularly where contracts do not contain robust fall-back provisions sufficient to cover the end of LIBOR, resulting in a risk of the contract failing.
For contracts governed by International Swaps and Derivatives Association (ISDA) standard terms, trustees may be able to adhere to the ISDA amending protocol to address this issue. For other contracts, including those not governed by ISDA documentation, it may be necessary to agree bilateral amendments with counterparties before LIBOR ceases to be published.
Shepherd and Wedderburn's banking and pensions team is currently advising pension scheme trustees on the impact of LIBOR cessation on interest rate and longevity swap contracts.
Originally Published by Shepherd and Wedderburn, February 2021
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