Pension Professor finds trustee investment in Leveraged LDI “speculation” and “ultra vires”

Philip Bennett, one of Britain’s top pension lawyers , has published a paper prepared for the APL Summer Conference held on 16th June, 2023

Leveraged LDI: Prudent deficit risk management or ultra vires speculation?

The paper looks at the underlying economic effect of LLDI and 3 of the key risks associated with it. It concludes that, on the correct construction of those 2 Regulations in line with the requirements of retained EU law, the use of repos and, for LLDI,
interest rate swaps is outside the powers of the trustees (and so ultra vires with consequential implications for their LDI Managers).

It identifies an exception for schemes with fewer than 100 members. It notes that the exception for borrowing for temporary liquidity purposes will not be available for the use of repos other than in very limited circumstances.

It follows from that conclusion, if correct, that the Pension Regulator’s guidance that scheme trustees can use LLDI is incorrect. It also follows that interest rate swaps with a total notional principal amount of more than £200 billion and repos funding gilt purchases of more than £60 billion, as identified in the Pension Regulator’s December 2019 survey, were prohibited by these  Regulations and were outside the powers of the scheme trustees (and their LDI Managers).

Drawing on a legal judgement against Hammersmith and Fulham Local Authority, Bennett argues that particular scrutiny will be needed of investment return assumptions for schemes using LLDI net of the expected future cost of repos and interest rate swaps in their next valuations.

It raises the general question of whether the accounts of companies with pension schemes using LLDI strategies need to ask whether additional provision is needed
for the effect of the “bleed” on the out of the money interest rate swaps.

It also concludes that LLDI is no more than a speculation (or carry trade) on long term vs short term interest rates. It was or may have been profitable during the period when the Bank of England’s QE programme was reducing short term interest rates to under 1%. However, an LLDI strategy in a QE environment, perversely, results in pro-cyclical behavior buying bonds in competition with the Bank of England with a negative real return and increasing reliance on the employer covenant.#

LDI or LLDI is ultra vires (i.e. outside the powers of the trustees (and their LDI Managers)) as a result of 2 statutory overrides contained in the 2005 Investment Regulations (read with the Pensions Act 1995, Section 117):
 the restriction on borrowing, and
 the restriction on the use of derivatives.

Impact of this opinion.

Phillip Bennett is Professor in Practice at Durham Law School and has advised Government on the drafting of CDC regulations. His opinion is likely to be taken seriously.

This paper is a challenge to trustees and those who advised them. It calls into question the guidance given by the Pensions Regulator and questions the legality of the LDI products offered to market by investment managers (authorised by the FCA).

Concluding his judgement against Hammersmith and Fulham Lord Templeman told the court in 1992

“.. the success of swaps depends on a
successful forecast of future interest rates.”

Bennett concludes that Leveraged LDI

does rather look like no more and no less a long/short interest rate speculation with a high degree of risk attaching to it.

Not only does he find LLDI beyond the trustees powers to invest but he identifies the reason for the law to take that position.

Financial Directors and Trustees who lost out when LDI blew up last year, should read this paper with particular interest

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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6 Responses to Pension Professor finds trustee investment in Leveraged LDI “speculation” and “ultra vires”

  1. jnamdoc says:

    Watch this story get buried. Expect to see the reference to naysayers’ re-surface.

    The DWP and TPR have staked their funding thesis on LDI in order to protect the PPF, and a whole industry has sprung up to service this – its all they know. What are they meant to do? Admit they didn’t really understand the risks?
    And it is getting worse – BoE / TPR dreaming up a 250bp ‘liquidity buffer’ (plus say 100bp ‘scheme specific’) has no proper basis, other than increasing the protection for the banks. And the accompanying calls for Trustees to place assets under the direct control of the LDI managers – tell me how that is not ultra vires! Trustees assets are to pay pensions, not cover the banks’ risks. If the banks promote the trades, they should cover of the risks.

  2. Peter CB says:

    In the earlier hearings on the LDI crisis the Pensions Regulator and the profession stated that the reason that smaller schemes using leveraged LDI were so badly affected was that the Trustees of those schemes didn’t have the knowledge and understanding to appreciate the risks and have appropriate contingency plans in place to manage the situation. In my albeit very limited and partial experience, the (5) schemes who lost out were almost entirely those where there was a sole professional trustee and those same schemes had long (often over 10 years) deficit recovery plans in place. I think there is a strong case for an analysis of the governance structure of the schemes who lost out.
    My views were strengthened by a response from a professional trustee in a pensions conference when discussing the value and role of lay trustees. The professional trustee said that acting as a sole trustee made it so much quicker for them to progress matters without having to involve others and explain why they were proposing a certain course of action, using equalisation of GMPs as an example. A previous survey also indicated that professional trustees did not view their appointments as long term. This probably indicates that as they were appointed by the Scheme sponsor, they saw their role as purely being a facilitator to achieve buy-out as quickly as possible.
    I think everyone seems to have forgotten the role of the Trustee is to exclusively act in the interest of the Members and to use and manage the fund purely for the benefit of the Members – or am I being heretical?

  3. Derek Benstead says:

    LDI, even if legal despite the prohibition on borrowing (I must read Philip’s paper), is over used, in my opinion.

    The timescale of a pension scheme is an important but seemingly not often considered factor. If a pension scheme is about to wind up within, say, 5 years but is not yet fully funded on a buy out basis, then LDI (if legal) could have a role to stabilise the buy out balance sheet and stabilise the remaining contributions required from the employer. But if that is not the situation, LDI is not necessary.

    Peter refers to schemes with long (over 10 years) recovery plans. What are they doing with LDI? These schemes are paying benefits as they fall due and the task of raising the probability of being able to pay the benefits in full as they fall due is not likely to be aided by risking leveraged losses on the gilt market in an LDI contract.

    To use a simple example, suppose a scheme is 50% funded when valuing liabilities using a gilt yield discount rate and the assets are a 2:1 leveraged LDI contract. The assets are £50m and the liabilities £100m. If the gilt market falls 50%, the assets will become nil and the liabilities £50m. Sure, the deficit contribution on the employer remains the same, at £50m, but no way does LDI reduce the reliance on the employer to pay contributions. Rather, with no assets, the scheme is wholly reliant on the employer to pay contributions. Buying LDI says “we can waste assets on leveraged losses because we can always rely on the employer’s deficit contributions.”

    In schemes with a long term future, we get to different investment decisions if we focus on raising the probability of paying benefits in full than if we focus on 1 year fluctuations in funding level.

    Cash flow driven investment strategies seek to avoid disinvestment risk. LDI creates a very large disinvestment risk which need not be taken. It is not right to call LDI “de-risking” without acknowledging the risk it introduces. it was fortunate that the events of September and October last year did not occur at a time of depressed equity markets.

    Don’t buy an investment you don’t understand is a good rule.

  4. Peter CB says:

    My contacts were with the Finance Directors of the sponsoring companies and was post the LDI Crisis. Because of my particular background these were generally long established not for profit organisations that may be asset rich but were income poor and hence the annual deficit payments were restricted although the guarantee to the pension scheme in a number cases included a charge over property. They had often appointed a sole or professional trustee to overcome issues with supporting lay or member nominated trustees as a decreased proportion of Members were current employees.
    Needless to say after the LDI crisis they were horrified to find the position their pension scheme was in. Particularly as they in their role as FD had not been properly briefed about the risks associated with LDI and particularly leveraged LDI. Instead the stock answer had appeared to be “the Pensions Regulator requires us to do it”. There had been no discussions about self-sufficiency or scheme consolidation as an alternative “end game”..
    My advice to the FDs was to ask the Trustee to provide them with a cash flow forecast for the duration of the recovery plan showing the projected income from investments as well as the employer contributions against the now reasonably well defined projected outflows to the beneficiaries and detail the assumptions used. . Such a cash forecast will highlight the need to sell capital assets to meet annual outflows and give an indication of the assets available to meet a possible buy-out at the end of the recovery plan.
    A cash flow forecast is the key planning document for nearly all businesses – why should pension schemes be any different!
    I also suggested they might like to query the use of accumulation rather than distribution investment funds.
    Lifting PPF benefits to 100% of Scheme benefits would give the Members additional reassurance that the end game was not being chosen to benefit the employer rather than the beneficiaries..

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