The Pensions Regulator has issued new guidance on leveraged liability-driven investments, expecting trustees to have liquidity for daily yield moves in addition to a stress buffer of at least 250 basis points. The Financial Conduct Authority has simultaneously published guidance for LDI managers, which requires them to consider client needs and review their approach to conflicts of interest. 

 

TPR’s guidance follows a statement by the Bank of England’s Financial Policy Committee on 29 March, in which the FPC recommended 250bps yield buffers for LDI funds.  

 

Pension funds had been told in November last year to hold liquidity buffers of 300-400bps in LDI funds, in a reaction to the market mayhem of last autumn. In late September and early October, a gilts sell-off was only stopped by the Bank of England stepping in as a buyer of last resort after the Truss government had announced unfunded tax cuts in its ill-fated Mini-Budget. 

 

     

Lou Davey, TPR’s interim director of regulatory policy, analysis and advice, said the regulator continues to monitor the use of LDI by pension funds. 

 

“The unprecedented market volatility seen last September clearly demonstrated there is the need for stronger buffers, more stringent governance and operational processes and more oversight by trustees,” she said. 

 

Davey added: “Trustees must understand the risks they carry in their investment strategy, and only use leveraged LDI if appropriate. Our guidance provides practical steps to ensure they achieve this vital balance, and we expect trustees to use it.” 

 

TPR’s new guidance says trustees investing in leveraged LDI should look at: 

 

TPR urges trustees to make sure they have processes for monitoring the resilience of LDI arrangements, and to understand the monitoring their advisers or the LDI managers perform, putting in place mechanisms so they receive necessary and sufficient information to understand and be able to react to risks. 

 

For their liquidity buffers, pension funds should have an operational buffer for day-to-day volatility in normal conditions and on top of this, liquidity for severe market stress so that yield moves of at least 250bps can be withstood. 

 

 
TPR added that the LDI arrangement should also operate a market stress buffer of a minimum 250 bps.  

 

“This minimum level assumes you are able to provide additional cash or assets to replenish the buffer within five days. If it is likely to take you longer, a larger market stress buffer may be appropriate,” the regulator notes. 

 

“A larger market stress buffer may also be appropriate in other circumstances, for example if the assets held within the buffer are more volatile than assets typically held in LDI arrangements. Similarly, if the composition of the LDI fund is intrinsically less volatile than a gilt related LDI fund, it may be acceptable to use a lower market stress buffer,” it added. 

 

Trustees are expected to consider how their processes work if there are cumulative cash calls, especially if these arrive in quick succession, as was the case last autumn. They also need to consider how they would top up these assets if they are sold, to ensure a continued supply of liquid assets for the LDI arrangement. 

 

It added that while the investment adviser or LDI manager will design resilience tests, trustees should be confident that these are sufficiently robust and provide them with the information they need to understand the risks.  

 

LDI managers have been given their own guidance by the FCA, published on Monday. 

 

The financial watchdog said that last autumn, “across the sector we saw significant deficiencies in the management of risk including stress testing and scenario planning; communications and client servicing; and operational arrangements. Cumulatively, these contributed to the market dysfunction and the consequent threat to financial stability.” 

 

It said managers should give special consideration to operational arrangements, including third parties, liquidity risks, the profile and capability of the investor, and the practical access to additional liquidity required in different conditions. 

 

The guidance puts emphasis on managers having to take account of their clients’ needs and understanding, as well as to manage various conflicts of interests that can arise between manager and client or between different clients. 

 
The guidance states: “While product selection decisions are made by pension schemes with their advisers, managers have a role in aiding schemes’ assessment of the LDI approach that is most appropriate to their needs. This would include both the LDI strategy and the contractual form, whether a fund or a segregated mandate. Some pooled fund clients may have been better served by having had greater operational flexibility than the pooled fund model offers.” 

 

It also notes a series of potential conflicts, with the FCA expecting managers to “review their approach to conflicts in the light of all the issues experienced and make any necessary improvements to how these are identified and fully managed”. 

 

Consulting firm XPS Pensions Group said it was not clear at this stage how any new responsibilities on LDI managers would be monitored or enforced. 

 

The firm also noted that there will be some level of increase in client servicing, which could increase risk for the LDI manager and result in higher fees charged to pension schemes to compensate the manager. 

  

“A theme running through the FCA announcement was one of all participants sharing greater responsibility for LDI arrangements being appropriate to achieve the end investor’s intended outcome,” observed XPS chief investment officer Simeon Willis.  

 

LDI managers will need to be asking questions about what a client is trying to achieve by investing in the LDI fund, so it can satisfy itself and evidence that the fund is the best approach all round, he said. 

 

Willis added: “A higher bar is being set. It’s clear that a siloed approach from investment manager or investment adviser, narrowly focused on their own role alone, is insufficient to meet expectations.” 

  

He said these more outcome-focussed developments mirror the messages around the responsibilities of regulators themselves, such as the Bank of England’s recommendation last month that TPR should be given an additional objective around financial stability.  

 

What changes has your scheme made to how it manages LDI since last autumn?