IA warns pensions world of long-dated credit herding
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The Investment Association is concerned about the proposed requirement that defined benefit schemes broadly match their cash flows, fearing it could lead to herding of investment strategies into long-dated credit.
Nearly nine months on from the start of the gilt crisis last autumn, its lessons are still being learnt by the investment and pensions industry as it seeks to avoid another panic.
The Bank of England has just launched a system-wide exploratory exercise to understand how financial institutions behave in times of stress and how their actions can amplify stress – the behaviors of liability-driven investment holders and managers last year being a case in point.
Could DB schemes be pushed into long-dated credit?
The problem has also been recognised by the industry, and some have since raised concerns about the Pensions Regulator’s DB funding code, which includes more prescription around investments.
It proposes that schemes reach low dependency on their sponsor and would then have “broad cash flow matching” in place, something that is set out as a requirement in the draft government regulations. The regulator explains this can come from asset classes including cash, government bonds and corporate bonds, as well as derivatives and illiquid and alternative credit. It does not specify if the matching assets should be long-dated.
Nonetheless, the Investment Association is concerned that pension trustees and their managers will seek out assets that more or less match long-dated liabilities. Imran Razvi, senior policy adviser pensions and institutional market at the IA, said the DB code could be creating herding risks in this way.
Cash flow matching can be achieved through different methods, but traditionally the approach has been to create longer dated cash flow using long-dated bonds, he said during a webinar organised by the Westminster Business Forum last Friday.
“An alternative approach might actually be to use short-dated credit, which doesn't explicitly target the scheme’s cash payment dates but does generate significant amounts of cash due to the higher annual maturity rate of the asset class,” he argued.
The incoming cash could be used to cover expected and unexpected outgoings, and surpluses could be reinvested in credit, he said.
The long-dated sterling credit market is relatively small compared with the euro and dollar market equivalents, he continued, and tends to be concentrated between a limited number of issuers.
However, Razvi added that the issue could be addressed relatively easily by changing the language in the DB code. The regulator should consider referring to ‘cash generative strategies’ or similar instead of cash flow matching, he said.
“That should at least signal to trustees that the alternative approach [of using short-dated assets] is permissible,” he said.
The regulator does not seem convinced there is an issue. A spokesperson for TPR said: “Our draft code allows flexibility in how schemes can meet the broad cash flow matching requirements in the draft regulations. We considered the risk of herding for bonds and gilts, and do not expect our code will materially increase the overall aggregate investment allocations to bonds.”
The spokesperson added: “We will publish a consultation response in due course but anticipate that, in practice, trustees will take a variety of approaches to determining the investment allocation for their schemes.”
When it comes to index-linked gilts, where some of the biggest distortions were seen last autumn, Razvi said the code would not be creating new herding risk as the risk is already present and in fact crystallised last year.
"We wonder whether this is something where policymakers perhaps need to consider ways that they might diversify the ownership of that part of the gilt market away from just the DB pension sector,” he said, to avoid further market upsets from pension funds’ needs and actions.
Pension investment consultants back in focus
Last year’s LDI crisis is not only driving industry to ask the regulator to change tack on its DB code but could also provide impetus to the regulation of investment consultants and the setting of consultant objectives by trustees.
Speaking at the same event, Harus Rai, managing director of professional trustee firm Capital Cranfield and chair of the Association of Professional Pension Trustees, said: “As a result of what happened in the autumn you are going to see a lot more changes to objectives.”
When the consultant objectives – a result of the Competition and Markets Authority’s order on fiduciary management and consultants in late 2019 – came into force, “what many schemes did was put generic objectives in place. That has changed. After that year, people started to really look at this and say, ‘We have a year to reset these objectives’,” said Rai.
Sponsors and schemes are discussing endgames and setting objectives around that, he noted.
Whether investment consultants will come into the regulatory perimeter of the Financial Conduct Authority, as recommended by the CMA, will also influence how trustees deal with objectives, Rai added.
The regulation of investment consultants "is one of the unfinished bits of business from the CMA review”, agreed Razvi, noting that most people across the broader investment and pensions industry concur with that view, adding: “It was something that sort of disappeared off into the ether.”
When the CMA made its recommendation, the FCA’s former director of strategy and competition, Christopher Woolard, wrote in a letter from early 2019 that it was supportive of this, as the size of the investment consultancy market meant a small change in the quality of service could have a significant impact on savers’ retirement outcomes.
However, the FCA cannot act on this recommendation alone. It would require the Treasury to legislate, but this has not happened to date.
Razvi said: "It will be interesting to see if Treasury now does take that forward. I think the LDI [gives] additional impetus. Not to suggest that any of the advice given was in any way incorrect, I think more just the fact that from the FCA's perspective it's uncomfortable to not be in a position to interrogate that area of the market."
Should the Treasury legislate to bring investment consultants into the FCA’s perimeter, the FCA will need to consult on the matter.