The Bank of England’s Financial Policy Committee has announced a recommendation to the Pensions Regulator that it specify “minimum levels of resilience” in relation to pension schemes’ liability-driven investments to avoid damaging feedback loops from being forced sellers of assets.
The FPC stated that the level of resilience required should absorb a gilt yield increase of at least 250 basis points (2.5 per cent).
This minimum is lower than the 3 per cent minimum that TPR recommended in its November 2022 guidance. However, details of the framework will be developed alongside other regulators, including the Financial Conduct Authority and offshore pooled fund regulators.
TPR chief executive Charles Counsell said: “We note the recommendations from the BoE’s Financial Policy Committee on LDI. The committee has clearly set out its expectations relating to the minimum level of resilience it wants trustees and fund managers to adhere to when using LDI, and I am pleased this builds on the guidance that we, and the national competent authorities, put in place in November.
The minimum level of resilience is lower than most pension schemes have been working to and as such this shouldn’t cause any issues for schemes whose funds were already in alignment with guidance
Simeon Willis, XPS
“We will be issuing updated guidance on LDI in April, taking into consideration the Financial Reporting Council’s recommendations,” he continued..
“In the meantime, I urge schemes to continue to follow our existing guidance, which is designed to ensure trustees achieve and maintain an appropriate level of resilience in leveraged LDI funds across pooled and segregated arrangements to withstand a fast and significant rise in bond yields, and improve operational governance of pension schemes.”
A moment of clarity
XPS Pensions Group chief investment officer Simeon Willis was not surprised by the announcement and said the industry has been expecting further developments on the management of LDI.
“The minimum level of resilience is lower than most pension schemes have been working to and as such this shouldn’t cause any issues for schemes whose funds were already in alignment with guidance,” he said.
“What we now know is that the regulator will be specifying what is acceptable, rather than simply letting schemes and their underlying fund managers decide that for themselves.
“This reflects the systemic risk that pension schemes represent to the wider gilts market.”
Potential for better balanced portfolios
The announcement will have little effect on how LDI funds or segregated mandates operate today, said LCP partner and head of investment Zuhair Mohammed. But TPR must deliver detailed regulation around this and the devil is going to be in the detail.
However, if the collateral buffer is set at 250bp as opposed to the 300bp to 400bp level, this could be beneficial for schemes, with pension scheme asset allocations ending up less like a barbell.
“If you place three-quarters or two-thirds of your money in an LDI mandate, and you still want to hit the same return, you must go for more aggressive return-seeking assets to make the numbers work. That’s a bad outcome,” Mohammed said.
“By reducing the level of the collateral buffer, you potentially have a more balanced and sensible portfolio for the risk you want to take.”
The gilt crisis achieved many multiples of the largest yield movements since 1981 according to the analysis, so 250bp remains a considerable magnitude, Mohammed said.
What could happen if everybody started doing the same thing simultaneously remains to be seen and that will be governed by the resilience test.
“We haven’t seen the calculations and simply don’t yet know how this resilience test will change over time. That kind of detail is where TPR is going to have to go,” Mohammed said.
“That’s going to determine whether, because of an inflationary environment, we suddenly double the amount of money we hold in LDI. There are plenty of unknowns at this point in time.”
A broader risk remit
The FPC also recommended that TPR’s remit be expanded to include an objective around wider financial stability and for this to be equally weighted with its other objectives.
That is a considerable obligation to request of TPR, said Mohammed, who questioned whether the regulator will have sufficient resources and capacity, given its existing remit.
Willis added that any change in TPR’s remit could lead to a very significant change in its approach in relation to a number of aspects far beyond LDI alone.
