Iain Clacher and Con Keating – authors of this blog

This morning the Pensions Regulator will be giving evidence to the Work and Pensions Committee’s inquiry into Liability Driven Investment.

Charles Counsell, the Chief Executive of the Pensions Regulator, wrote a letter to the Lord’s Industry and Regulator’s committee on the 29^th of November on questions of legality of LDI, which were posed by that committee. The submitted letter confirmed that the views of the Pensions Regulator as to the legalities of leveraged LDI and that the issue of the legal status of LDI had been confirmed as in order by its in-house legal team, but that no external counsel’s opinion had been obtained. As well as this, the letter made no reference to the fact that Regulations 4 and 5 of the Occupational Pension Schemes (Investment) Regulations 2005 were giving effect to an EU Directive designed to prevent leverage in pension schemes.

We have submitted a letter to both the Lord’s Industry and Regulators Committee and to the Work and Pensions Committee covering the substantive legal elements and, doubtless, that will be published in due course.

This blog will address the letter from TPR (other than the substantive legal issues covered by that letter) by examining it in detail, and may provide an interesting background to what TPR has to say today.

We follow our previous convention of colouring quoted text blue.

LDI as an effective hedging tool

We support hedging as a tool to protect pension schemes from downside risks and to match the movements in a scheme’s liabilities to movements in its assets.

As with much of the discussion around LDI, we have the confusion between the ultimate liabilities of the scheme and the discounted present value of liabilities. LDI does not match the movements of a scheme’s assets to it liabilities – it matches the assets to the estimated present value of projected liabilities. The actual projected liabilities are not affected by interest rates and change only slowly in ways which are independent of interest rates. Indeed, given that trustee responsibilities are the actual liabilities, not their estimated present value, this ‘matching’ may itself be unlawful for them if such matching is costly.

LDI has been used effectively for hedging for around 20 years in a way that is consistent with the statutory regulatory framework.

LDI has been around for twenty years, but for far less in its current highly leveraged form. As to consistency with the legislative requirements, that is the matter in dispute, which TPR have yet to provide an explanation as to how it is consistent with the approach to interpreting UK legislation giving effect to an EU Directive designed to prevent leverage.

Scheme trustees that used LDI to lessen the impact of falling or volatile interest rates over the past two decades have been impacted less by previous market shocks, such as the 2008 financial crisis and the recent pandemic.

This is an intriguing assertion offered with no empirical evidential support. What evidence do they have to support this? We note that there is no mention of deficit repair contributions here, which at more than £200 billion over the past twenty years will have contributed greatly to improved funding status for schemes.

We have considered in detail the March 2020 pandemic market shock in another blog “LDI and Gilt Market Disruptions: Some Meanderings” which will shortly be published here. Our conclusion is that LDI played no significant role in the resolution of the March 2020 event.

Overall, for many schemes, LDI has made funding more stable and improved funding levels.

However, the trustees, acting prudently, cannot, without being in breach of trust, derive a discount rate from gilt yields which is higher than the prudently assessed expected return on the scheme’s assets, net of its prudently assessed expected cost of borrowing via the repo market, over the same duration as the assets funded by that borrowing. The same point applies to the future payments that will become due from the trustees to the holder of the floating leg where the equivalent leverage has been used with fixed/floating interest rate swaps.

Any understanding of the funding improvements is built on foundations of sand if it does not take account of the fact that a 20-year period which included 13 years of quantitative easing is now being replaced by a period of quantitative tightening, during which the interest rate yield differential will move from a very profitable but high risk speculation to a negative yield where the cost of the short term repo borrowings exceeds the yield on the 20-year plus to maturity gilts bought during this period (and mutatis mutandis for interest rate swaps).

Now we have LDI not merely hedging liability asset to variation but also improving funding status. There is an implicit claim here that the costs of a hedging portfolio, which are substantial, are exceeded by the returns coming from the strategy. This could only be achieved by buying exceedingly risky securities or by gearing (or leveraging) the portfolio, that is borrowing to buy more securities. The asset portfolio has to be riskier than might otherwise be relative to the prudently diversified portfolio expected of trustees.

Note that the measure of success is the funding level, a ratio which, as we have seen recently, can mislead materially.

This benefits savers, sponsoring employers and the Pension Protection Fund (PPF).

Savers is a rather odd word choice in the context of DB. Why no mention of members of the DB pension scheme who are not savers? They are being provided with deferred remuneration derived from their employment with the scheme’s sponsoring employer. Higher funding levels certainly benefit the PPF, but it is far from obvious that stable funding ratios would. A scheme staying 50% funded offers no obvious benefit or cost reduction to the PPF.

It is interesting that sponsors get mentioned. Why should a sponsor want the scheme to be stable, having taken no account of the sponsor’s risk exposures?

The sponsor is the guarantor of the pension scheme. In fact, the costs and risks it faces from the scheme are related to the rate of return on fund assets needed to achieve the promised benefit payments. As we have just seen huge losses of asset value, the risk to the sponsor has risen dramatically (and even more so when the cost of the payments on the borrowing/leverage exceed the locked in fixed interest returns on 20 year plus gilts).

If assets move differently from liabilities, that can create a funding gap and place a burden on the sponsoring employer for further contributions and a greater risk of members not receiving their benefits in full.

The only metrics which TPR is concerned with are the funding ratio and the deficit repair contributions following from that flawed metric. We would like to see TPR’s evidential base for this assertion of benefit to the sponsor. We suspect it would amount to no more than some schemes speculated, by economic borrowing via the repo market or leverage through swaps to seek to arbitrage the difference between the long-term yield and the short-term yield. Such schemes are now locked into that (now unprofitable) speculation (with more and more collateral to post). The net of those costs return on scheme assets is not going to be sufficient meet the assumed higher discount rate for valuing the present value of the future pension payment obligations.

So, a strategy to reduce the cost to the employer and to reduce dependency on the employer has, for those who did not exit the speculation at the end of 2021, led to a funding gap and increased the burden on the sponsoring employer for further contributions and greater dependency on the employer covenant.

The funding gap being discussed here is a deficit as measured by the funding ratio – that is the basis on which TPR insists on deficit repair contribution schedules. We now have a situation in which schemes are reporting surpluses by that metric, but scheme assets require far higher rates of return than previously to achieve benefit sufficiency (and see above on the interest rate speculation reverses). Note it will take a bit of time for this net reduced or net negative return on the scheme assets to feed its way into valuation results.

There is no evidence of any relationship between funding gaps measured in TPR’s manner and risk to members. The risk to members is independent of the estimated present value of liabilities but is related to the current amount of funding and the relation of that to the projected benefit. The claim that funding gaps increase the risk of members needs evidential support to be credible, and we do not believe it exists.

In our guidance and communications, we have consistently reminded trustees to have contingency plans in place to manage liquidity and collateral calls in the event of interest rate rises.

This is simply not true. In earlier communications, where it was mentioned, liquidity was given a cursory mention and collateral calls have only appeared in far more recent times, as has ever more increasing detail as to what TPR expects of trustees and their advisors. Previously, there was little detail on this, and it is only since the crisis in September have we seen anything close to detailed guidance that reflects the risk of leveraged LDI. We would suggest that TPR be asked to produce their first mention in communications and guidance of each term.

Trustees have a fiduciary duty to act in the best interests of their savers.

This is not true. Trustees have a duty to scheme members. While this might be something that has slipped past in the editorial process at a time of considerable pressure, to use the catch-all “savers” is worrying given that it is wrong.

They are responsible for their scheme’s investment strategy and are required to take advice in relation to their scheme’s investments.

Throughout the crisis, the Pensions Regulator has consistently tried to put any and all blame on scheme trustees and their advisors, when in many cases they have been active proponents of LDI and Leveraged LDI. As we have said elsewhere, there is enough blame to go around in all of this and some of it must land at the Regulator’s door.

The letter then continues with a section on Borrowing vs Derivatives which is the subject of our letter to the two committees, which we will not cover beyond saying that we do not agree with TPR’s interpretation of the law nor with their classification of repo as a derivative.

The session can be watched live from 9.30 am on December 14^th and we hope that there will be much more detail forthcoming at the public hearing than was found in this letter.

Live session can be found here: