UK pension trustees urged to ensure resilience of LDI arrangements

In new guidance, The Pensions Regulator has set out the practical steps pension schemes and their trustees should take to manage risks when using leveraged LDI, placing clear responsibilities on trustees to safeguard the resilience of their funds against market volatility.

Trustees are now required to have a better understanding of the risks and benefits of LDI and where it fits with the scheme’s overall investment strategy.

When working with external providers, such as investment or fiduciary mangers, investment advisers and LDI managers, trustees need to clearly understand the service each party is providing in respect of LDI, their respective role and responsibilities, what processes must be followed, and any discretion or limitations applicable to those services. These services, TPR stated, should be appropriately reflected in legal agreements and contracts.

The guidance contains new and detailed requirements to set, operate and maintain a collateral buffer, and to test the resilience of LDI investments and processes regularly, in a bid to make sure funds can withstand adverse changes in market conditions.

On resilience testing, trustees should work closely with their investment advisers and LDI managers, who are to design these tests. However, the trustees will be accountable for making sure advisers and managers are capable and well-resourced for LDI management, and for recording the outcome of the tests and addressing areas of concern.

The updated guidance comes six months after last autumn's market turbulence, when a sharp and rapid fall in the price of UK government bonds, known as gilts, was recorded following then-chancellor Kwasi Kwarteng’s ‘mini-budget’. The drop in price led to widespread selling of gilts by pension schemes with LDI arrangements.

Generally, the UK government bonds are considered as low risk and have been popular with UK defined benefit pension schemes pursuing LDI strategies, where the focus of those investment strategies is on ensuring the liabilities of the investor are covered rather than on necessarily maximising the value of the assets invested. However, the drastic price changes last autumn spurred concerns that some pension schemes would be unable to meet their liabilities and it prompted action from the Bank of England to address what it described as “risks to UK financial stability from dysfunction in the gilt market”. 

Pensions expert Cameron McCulloch of Pinsent Masons said: “LDI undoubtedly still has an important role to play for many schemes in terms of their overall investment strategy, but the new guidance puts a greater focus on trustees having the right governance and controls in place to reduce the risks associated with LDI.

The new guidance also places greater weight on robust monitoring processes. Scheme trustees need to monitor not only the resilience of their schemes’ LDI arrangements, but also the level of monitoring their advisers or LDI managers perform routinely. They are required to put in place mechanisms to ensure that they are receiving necessary and sufficient information to allow them to understand and react to risks.

“If trustees use LDI, they should review the guidance and consider how their approach to LDI stacks up against the regulator’s views,” said McCulloch.

“This is unlikely to be the last we hear about LDI-related regulatory guidance. The FCA has also recently published guidance for LDI mangers on increasing their resilience to future market volatility and we expect there to be an ongoing focus on this area in the coming months,” he added.