LDI’s origin story is crucial to its future.

The question of how leveraged LDI came to become business as usual for DB pension schemes is raging at the Work and Pensions Committee.

After a request from Committee Chair – Stephen Timms – the Pensions Minister has sent this reply.


In case you find this formal style difficult, here is a summary.

Con Keating is pointing  to the right  regulation.

The DWP asked pension practitioners if they’d like to use derivatives and the repo market to manage the risks of pension schemes

The pension practitioners said they would – and would feel restricted if they couldn’t.

The DWP asked their lawyers – and their lawyers said “ok”.

Meanwhile, Baroness Sharon Bowles is not appeased, she has written to the Work and Pensions committee and you can read the entire letter here.

Here is how Bowles came to be involved in that decision taken in 2005

IORPS was completed before I became an MEP (2005) but from 2009, while ECON chair, I was asked to be a keynote speaker and panellist to discuss review of IORPS at Commission conferences and events. There were also calls for investigation within the ECON committee. Informal advice given to me from HMT at various times was to defend IORPS and prevent it from being revised to be more like Solvency 2. I was also told ‘it was a difficult transposition and we don’t want the Commission opening it up’.

The difficulty I was given to understand was to make the words cover what was already practice in UK DB schemes. The ‘wriggling’ (my expression) was regarded as justified due to the systemic size of DB schemes in the UK, few other countries having DB schemes and thus the Directive being ‘mainly about us’.  (my bold)

So by 2009, LDI was already sufficiently established in the UK, to make a challenge to the legitimacy of using leverage in pensions, awkward. Nevertheless , Baroness Bowles argues that the wishes of the UK occupational pension schemes do not override European law and that the transposition of European law into UK legislation was doctored to satisfy pension practitioners.

On borrowing: The directive’s general prohibition on all borrowing  has been narrowed in UK transposition to ‘borrowing money’.  The effect is to permit borrowing, or leverage, through other mechanisms. Repo is a form of economic borrowing though it is claimed by others (eg L&G in evidence to Industry and Regulators Committee) not to be borrowing on the basis that it is a sale and a repurchase. Leverage is defined in dictionaries as borrowing to invest. The Pensions Regulator claims in a letter to the I&R committee that repo is a derivative.

On derivatives: The directive allows Investment in derivative instruments for reduction of investment risks or to facilitate efficient portfolio management. The UK has left out investment – relevant because LDI derivative and borrowing operations are used for liability matching not reduction of investment risk. UK also added Including the reduction of cost or the generation of additional capital or income with an acceptable level of risk  as a part of ‘portfolio management’. The added words imply allowance of leverage (borrowing), with the narrowing of the borrowing definition only to money playing an enabling part and the Directive’s condition to reduce investment risk has been swapped to allowing increased ‘acceptable levels’ of risk.

Bowles letter references the sections of the consultation into the 2005 regulations which Laura Trott says the DWP used to justify the tinkering with European law.

Was there a deliberate attempt to bypass European law?

The 2005 consultation referenced by the Pensions Minister is now archived but Sharon Bowles has got a copy from the House of Lords library and her letter goes on to detail what is said.

 The consultation response clearly elaborates that the changes were indeed made to allow non-money borrowing, leverage through derivatives and investment in collective investments and insurance products with those characteristics.

“Repo is different from “money” borrowing as what’s borrowed are gilts rather than cash deposits.

In Paragraph 2 it is made clear that the original regulations consulted upon were  copied out from IORPS “concerns were expressed that the draft regulations’ copy-out approach to transposition of the Directive might lead trustees to adopt excessively cautious investment strategies”

The examples of “excessively cautious investment strategies might include the Bank of England’s approach to LDI which involves little or no borrowing but results in a 50% contribution rate.

Then in Paragraph 9 it explains “One respondent was concerned to have received legal advice that the regulations would prohibit certain existing investment strategies”.  The Government response was to draft around that to attempt to make them legal.

Presumably this would have meant that certain leveraged leveraged LDI strategies already in the market in 2005 would have be unwound.

Paragraph 9 goes on ..   “The terms “derivative instruments” and “efficient portfolio management” will be defined in regulations: “derivative instruments” in terms of the arrangements listed in MiFID2 ; and  “efficient portfolio management” to include an intention to reduce risk and costs or generate additional capital or income with an acceptable level of risk (it remains for the trustees or delegated fund manager (as appropriate) to determine the level of “acceptable” risk based on the particular circumstances of their scheme).”

This is where the substitution of “general risk“, mentioned by Laura Trott,  for “investment risk

Paragraph 10 explains “The interaction between regulation 5, which restricts borrowing and prohibits trustees acting as guarantor also caused concern, respondents wanting reassurance that the regulation would not affect activities such as gilt repurchase agreements, non-financial borrowing, swaps, derivative instrument and borrowings by scheme subsidiaries, nor the use of borrowing or derivatives in indirect investment vehicles such as pooled funds, hedge funds and property unit trusts” (my bold)

The tweaking of the EU rules to define borrowing as only the borrowing of cash (not gilts). was how leveraged LDI got away with it.

And the Government response is “Section 36A of the Pensions Act 1995 allows regulations to impose restrictions on trustees’ or fund managers’ ability to borrow money. The restriction in regulation 5 is thus limited to cash borrowing. It is not the Government’s intention to restrict the activities in the example given above. We believe that defining the term “derivatives” will help to clarify the position legislatively”.

Bowles is clear that this distinction was not historic

It is worth noting that the ‘borrowing money’ provision in the Pensions Act 1995 was not a pre-existing one, it was inserted by the Pensions Act 2004, as part of the transposition of IORPS 2003.

Is this all legal nicety and hasn’t Brexit made it irrelevant?

No it isn’t. If the WPC considers that Sharon Bowles is right to argue that the DWP had used the legislation in 2004 and regulation in 2005 to create a loophole for leveraged LDI, then the DWP might find itself liable for some of the mess that schemes find themselves in , in 2022.

If one of the DWP’s foundation stones for the forthcoming draft Funding Regulations and the now-published draft  DB Funding Code is that “de-risking” using leveraged LDI is ok, then the origins of that opinion are very relevant to the legislation’s getting royal assent and TPR’s powers to use the DB funding code – extended.

The question of how the law came to be written has a complex origin story, but it doesn’t need to be ignored because it is complex or 17 years old. A challenge has been made to parliament that leveraged LDI should not be permitted going forward and this is the legal basis for that challenge.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to LDI’s origin story is crucial to its future.

  1. Byron McKeeby says:

    The 2005 Regulations also preclude trustees from “act[ing] as a guarantor in respect of the obligations of another person where the borrowing is liable to be repaid, or liability under a guarantee is liable to be satisfied, out of the assets of the scheme.”

  2. Bob Compton says:

    Byron makes a key point. Can LDI leveraged contracts collateral calls be seen as guarantees being met by Trustees for the benefit of meeting The Sponsoring Employers Accounting stability needs? By definition the collateral calls do not meet the Trustees investment funding obligations re payment of member benefits as and when they fall due. And legally the sponsoring employer is “another person”.

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