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