In the wake of the recent LDI liquidity crisis, the Pensions Regulator (TPR) has released new guidance for trustees, outlining practical steps to mitigate risk when using leveraged liability-driven investments (LDI). The guidance, published on April 24, replaces previous advice issued by TPR in October and November 2022. The crisis, triggered by the government’s “Growth Plan 2022,” caused significant market turmoil for trustees employing leveraged LDI strategies, leading to cash flow challenges and the need for asset sales or temporary liquidity support from scheme sponsors.
Various regulatory bodies, including the Work and Pensions Committee (WPC), the House of Lords Industry and Regulators Committee (IRC), the Economic Affairs Committee, and the Bank of England’s Financial Policy Committee, have scrutinized the LDI crisis. TPR, taking into account recommendations from these bodies, particularly the Financial Policy Committee, has formulated the updated guidance.
The Guidance Highlights Five Key Areas:
1. Investment strategy: Trustees are advised to evaluate the benefits and risks of LDI within the broader scheme context and investment strategy. Factors such as risk tolerance, liquidity, and the ability to meet payment obligations during stressed market conditions should be assessed. Documenting changes to the investment strategy, including expected risks and returns, collateral provision, timeline, and adherence to TPR’s resilience standards, is emphasized.
2. Collateral buffers: Trustees are required to maintain cash, cash equivalents, and/or assets as buffers to meet collateral calls during short-term adverse market changes. The buffer consists of an operational buffer for day-to-day volatility and a market stress buffer for periods of market stress. The market stress buffer must be at least 250 basis points (bps) and replenished promptly if drawn upon. If a scheme cannot replenish the buffer within five days, a higher minimum may be appropriate. The operational buffer has no minimum requirement, but both buffers are cumulative.
3. Resilience testing: Trustees, with assistance from investment advisers or managers, should regularly test the resilience of their LDI investments and processes, particularly during significant market changes or funding and investment position alterations. Testing involves evaluating LDI arrangements against scheme-specific scenarios and determining the extent of market movement necessary to trigger events like replenishing the market stress buffer.
4. Governance: Trustees must understand how their investment governance model affects LDI implementation. Roles, responsibilities, processes, and limitations related to LDI should be documented. Key strategic decisions should not be delegated, and the appropriateness of other delegations should be reviewed periodically.
5. Monitoring: Trustees are required to establish monitoring processes for LDI arrangements, considering TPR’s existing 2017 guidance on monitoring defined benefit (DB) investments. Collaboration with advisers is crucial to determine the required information and frequency of monitoring. In some cases, an LDI oversight sub-committee might be recommended.
Impact and Future Developments:
The Guidance is not expected to significantly affect schemes already implementing similar risk management practices. Many schemes have already increased collateral buffers to around 300-400 bps, surpassing the minimum requirements outlined in the guidance, according to TPR’s report in January.
While trustees can seek advice from investment advisers and managers, they bear ultimate responsibility for their scheme’s investments. The Financial Conduct Authority (FCA) has issued new guidance to ensure resilience in LDI portfolios, acting as a regulatory second line of defense for trustees.
The LDI saga is not yet over. TPR is exploring ways to enhance LDI data collection, including the possibility of introducing an LDI-related notifiable event. Additionally, the implementation of changes to the defined benefit funding regime has been delayed due to last autumn’s events. The draft regulations for T
PR’s revised DB Funding Code of Practice will not be finalized until the recommendations of the WPC and IRC are published and considered by the Department for Work and Pensions (DWP). TPR’s revised code is also expected to be delayed until April 2024.
Trustees are not obligated to follow the FCA’s guidance directly, but it is expected to indirectly impact schemes. However, it remains unclear when trustees will benefit from this guidance, as compliance and regulatory obligations for managers may not align with clients’ contractual obligations.
Some industry commentators have called for additional details from TPR to help trustees better understand their obligations, given the complex and challenging nature of monitoring funds’ portfolios and strategies.
