The Pensions Regulator has set out its expectation that liquidity buffers be maintained across pooled and leveraged liability-driven investment mandates, going beyond the demands of Irish and Luxembourgish regulators.
UK defined benefit pension schemes faced a liquidity crunch following the government’s doomed September “mini” Budget, with a subsequent spike in gilt yields triggering collateral calls from LDI managers.
On November 30, the Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier – known together as the national competent authorities – noted an improvement in the resilience of sterling-denominated LDI funds across Europe, with an average yield buffer of around 300 to 400 basis points having been secured.
This buffer refers to the level of yield adjustment on long-term gilts that an LDI fund is insulated from, or may absorb, before its capital reserves are depleted. LDI funds trading in the UK are based exclusively in the Republic of Ireland and Luxembourg.
The NCAs expect that levels of resilience and the reduced risk profile of GBP LDI funds are now maintained, and do not consider that any reduction in the resilience at individual sub-fund level is appropriate at this juncture
Bank of Ireland and Commission de Surveillance du Secteur Financier
“Given the current market outlook, the NCAs expect that levels of resilience and the reduced risk profile of GBP LDI funds are now maintained, and do not consider that any reduction in the resilience at individual sub-fund level is appropriate at this juncture,” they said, referring to pooled funds.
NCAs need to be informed if funds’ resilience falls
Speaking to the House of Lords’ Economic Affairs Committee on November 29, Bank of England governor Andrew Bailey noted that there are around 175 LDI pooled funds operating in the UK market, in which 1,800 pension schemes are invested.
“[Pooled funds] had to go to the parent funds and get the trustees to agree to transfer the liquidity, and in the time available, which was short, and on the scale needed the very clear message we were getting […] was that they were not set up to do that,” he said.
“Had we not found a way around it, they would have gone into a form of technical default.” The BoE announced a £65bn bond-buying programme on September 28 in an attempt to stabilise markets.
Those that deem it necessary to “advertently” lower a fund’s resilience should inform the supervising NCA of their plans, the regulators’ notice said, adding that they must document their justification for reducing the buffer. They should also detail their plans for returning the fund to current levels of resilience “in the event of increased market volatility”.
Should a fund’s resilience decrease inadvertently due to market movements, the NCAs expect the fund to have means to recapitalise or remove risk from their portfolios by reducing their exposures.
Segregated leveraged mandates ‘face the same market risks’
TPR endorsed the NCAs’ proposals, issuing its own guidance to cover a greater portion of the LDI market.
In early October, the watchdog issued guidance urging schemes to “review their liquidity, liability hedging and governance processes, suggesting that managers of their LDIs could be granted power of attorney over some assets to quicken trading”.
It extended its expectations on liquidity buffers to include segregated leveraged LDI mandates and single-client funds, arguing that “they face the same market risks and operational challenges”.
“If a scheme is not able to hold sufficient liquidity, or is unwilling to commit to that level of liquidity, they should consider their level of hedging with their advisers to ensure they have the right balance of funding, hedging and liquidity,” TPR said.
“For schemes that decide to adopt an investment strategy with a reduced hedge, this should be done in a predetermined manner by the trustee, having taken appropriate advice.”
The regulator echoed the NCAs’ request that funds set out plans for increasing their resilience in response to market volatility.
It encouraged trustees to confirm that authorised signatories are up to date and that decisions can be made in “stressed market conditions”. Required collateral amounts should be calculated and the dates for when collateral or margin calls need to be made should be specified.
Trustees should also confirm which assets would be sold, when the sell order would be issued and when the cash is settled.
“This should take account of the settlement period of the various asset classes or the dealing dates of pooled funds and any potential risk that any fund may defer redemption if they are unable to meet liquidity needs, or become considerably less liquid in such conditions,” TPR said.
“Trustees should liaise with LDI fund managers and ask for an assessment of the liquidity of the assets that the schemes intend to use to meet cash requests.”
During the crisis, the spike in yields supported improvements in the funding levels of many schemes. Schemes reached out to sponsoring employers in order to secure additional cash in order to preserve hedging ratios.
LDI pooled funds determined Bank of England intervention
The Bank of England’s bond market intervention was determined by the lack of ability of liability-driven investment pooled funds to receive the liquidity needed from schemes to rebalance in a short period of time, Andrew Bailey has revealed.
TPR said credit lines with sponsors should be documented and reviewed regularly, with the emphasis being on immediate flows of cash.
“When such arrangements are in place, this line of credit can be used in place of investment liquidity,” it said.
“Any facilities must only be utilised on a short-term basis and for liquidity purposes.”
TPR said that it would publish a further update in its Annual Funding Statement in April 2023, along with any other statements or guidance if necessary.
