In a strongly worded report, the House of Lords Industry and Regulators Committee has criticised the use of leveraged liability-driven investment (LDI) strategies by defined benefit (DB) pension funds, which played a significant role in the financial turmoil following the September 2022 fiscal statement.
In a letter today to Andrew Griffith MP, Economic Secretary to the Treasury, and Laura Trott MP, Minister for Pensions, the Committee raises concerns that regulators had not focused sufficiently on the risks and dangers that borrowing to boost investment returns could pose to pension scheme finances, and wider financial stability in the event of interest rates rising.
The Committee has several findings
- liability-driven investment strategies, particularly those that use leverage, were created as a solution to an artificial problem created by accounting standards, which drive sponsoring companies to focus heavily on current, rather than long-term, estimates of pension deficits. Pension schemes aimed to hedge volatility in these estimates by investing in bonds, but due to the low returns these offered and the need to close their deficits, they borrowed to boost their returns.
- the use of borrowing and derivatives for these purposes is not permitted by the relevant underlying EU legislation, which appears to have been permissively transposed in the UK in order to allow pension schemes to continue using such strategies.
- it is likely some pension scheme trustees were not aware of the potential implications of their LDI strategies and their decision-making struggled to match the pace of markets. This has led them to become dependent on advice from investment consultants, whose advice to schemes is currently unregulated and may not be comprehensive over the whole portfolio or cover operational requirements.
- despite calls for more information and a review of stress tests from the Financial Policy Committee, regulators in the sector appear to have been slow to recognise the systemic risks caused by the concentration of pension schemes’ ownership of assets such as index-linked gilts, and the increasing use of more complex, bank-like strategies and instruments by pension funds.
It makes some straightforward recommendations
- the Government and the UK Endorsement Board should review whether the current system of accounting for pension scheme finances in company accounts is appropriate and whether to introduce a system that does not drive short-termism in pensions investment. More schemes should be allowed to take an asset-based approach if this is appropriate for them.
- the Government should review the relevant regulations and consider whether the use of repos and derivatives should be more tightly controlled and supervised in future. If schemes are to continue to use leveraged LDI, there should be far stricter limits and reporting on the amount of leverage allowed in LDI funds.
- the Government should ensure that investment consultants are brought within the regulatory perimeter as a matter of urgency. Following this, regulators must have heed to the non-professional nature of trustees in their regulation of consultants and ensure consultants are liable for their advice. Regulators should ensure they have more information on the leverage present within pension scheme finances and that stress tests are conducted. The Government should consider giving the Prudential Regulation Authority a role in overseeing pension schemes.
- the Pensions Regulator should be given a statutory duty or ministerial direction to consider the impacts of the pensions sector on the wider financial system. The Financial Policy Committee should continue to take the lead on systemic risks to financial stability and should be given the power to direct action by regulators in the pensions sector if they fail to take sufficient action to address risks.
In concluding the Committtee’s work on this subject, the Chair Lord Clive Hollick wrote
“The evidence we heard overwhelmingly suggests that the use of LDI strategies caused the Bank of England intervention. If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction, rather than a downward spiral in government debt markets that threatened the UK’s financial stability and led to significant losses as pension fund assets had to be sold in order to meet LDI liquidity requirements.
The impacts of accounting standards and the widespread adoption of leveraged LDI have transformed pension schemes from being long-term institutions into ones focused mainly on short-term volatility in prices and interest rates.
We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the Government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes. This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again.”
Still no figures on the costs to the balance sheet of the pensions. So much for transparency
Brexit type arguments seem to be accepted as the new norm.
At least with DC I understand where the risk is and can control it to some extent.
The reporting periods for schemes are long – however, we should get a very good handle on the overall impact from the ONS release in March of their survey data to September 30th. There is of course also the annual returns to the Pensions Regulator but that only sees the light of day in the next Purple Book.
It seems that most agree that the problem is the leverage rather than LDI, which is a good thing, I believe. At its core, LDI is a starting point for trying to keep a balance sheet in balance: structure the assets funding the liabilities in a way that keeps them both moving together as interest rates rise and fall. Leveraged LDI does not seem to me to be LDI at all. It is something else, just as investing in equities to back bond like liabilities is something else. I don’t consider financial economics to be either austere or to prohibit a particular investment policy. I think instead that FE advocates a starting point and on departing from that starting point, be sure to understand what you, the fiduciary, are doing.
Not sure I share your sense of balance, David.
If interest rates rise, with some loose correlation with rising rates of CPI or RPI inflation, and liabilities are uncapped, you might expect liabilities to increase, while the value of fixed income assets (if “invested” in your preferred version of LDI, without leverage) may be expected to fall.
The only reason your own preferred measure of liabilities appears to fall in synch with the assets is because you’re using a higher marked-to-market discount rate to discount liabilities.
I’m no accountant, but I would suggest focusing on expected future cash flows is a more prudent approach than obsessing with an elastic balance sheet approach which yo-yos with market tides.
Is there a value of a future cash flow inherently more correct, or prudent, than that ascribed by the market? The pension liabilities don’t have a readily observed market value but if similar cash flows in terms of term and risk do have such an observable market value, then isn’t that a good proxy?
Why do you actuaries seem to me anyway to want to reduce liabilities to a single (discounted) value, using market prices (subject to all the limitations of lot sizes and liquidity or illiquidity) to inform your discount rates, rather than professional judgment?
I don’t profess to know how annual pensions increases are determined in Australia, but here in the UK they are a confusing mix of RPI, CPI and LPI (RPI or CPI capped at 5% or 2.5%). The market in “matching” gilts tends to offer (uncapped) RPI only.
I’ve quoted Ben Graham elsewhere on Henry’s website. Another of Graham’s is this: “Investment is most intelligent when it is most business like.” I would suggest it is better, ie “business like” and common sensible, to manage a DB pension scheme’s investments to pay liabilities using cash flows, comparing expected with actual, than by focusing on a single snapshot of a discounted net present value.
This chaos is not new The ASPF was formed in 1923 now called the PLSA We need to think who benefits from the constant reorganisation of pensions and how far down the list we have to go before we find the beneficiary of the pension
Byron, we used to have professional freedom to form a basis for discount. I remember actuarial bases for valuation that were openly ridiculed in the financial press and elsewhere as firstly opaque and secondly unrealistic. But those days have gone. Regulators paid heed to the accounting lobbyists. And I’m ok with the concept that similar cash flows should have similar values.
Perhaps certain professions deservedly lost their “freedoms” because they placed commercial gain above professional ethics and integrity?
In the UK DB space I could argue that cash flows which have to accommodate various forms of annual increase, tax-free lump sums and transfer values based on varying bases, are not really that “similar” to the market assets you seem in such thrall to, Mr Australian Actuary.
We agree to disagree.
On your second point, you misunderstand the nature of layered liabilities. I don’t hold that against you. You are one of many.
On your first point, that is an undisguised slur, unworthy of a gentleman.