Member Article

On 23 September the Government announced its ‘Growth Plan 2022’ (Growth Plan). It was intended, the Government said, to tackle rising energy costs, bring down inflation and help businesses and households alike.

Instead, it caused a sudden and significant rise in interest rates which caused havoc for defined benefit (DB) pension schemes with liability driven investment (LDI) strategies. The issue exploded in the pensions press in early October but where are we now, almost three months on from the Growth Plan’s announcement? To answer that question, it is first necessary to look at what led to the crisis.

LDI

LDI strategies focus on matching a DB scheme’s assets with its current and future liabilities to ensure it can pay benefits when they fall due. Trustees can also leverage (borrow money) to achieve closer matching. LDI (leveraged or not) aims to protect, or ‘hedge’, a scheme’s funding position from adverse movements in interest rates and inflation which would otherwise increase liabilities and upset the match.

One way of hedging this risk is a swap: a contract between trustees and a provider under which they agree to exchange payments over a period depending on market conditions, for example when interest rates change. Falling interest rates increase scheme liabilities, so the swap provider makes a payment to the scheme to maintain the matched position. Trustees give collateral to the provider, which the provider then calls on for payment when interest rates go back up and the liabilities decrease.

Schemes can generally plan for movements and make sure they have enough liquid assets available to pay the swap provider when it makes a collateral call. As we saw in the wake of the Growth Plan though, things can go wrong when the market changes very quickly.

What went wrong?

The Growth Plan introduced significant tax cuts to funded by increased Government borrowing, causing a shock to (already sceptical) investment markets. The shock led to an abrupt drop in gilt values and a corresponding and significant rise in gilt yields (a type of interest rate). That meant swap providers made sudden and large collateral calls that trustees were not prepared for. It was unprecedented, and even trustees following the Pensions Regulator’s (TPR) guidance on LDI liquidity planning to the letter were not equipped to respond. There simply wasn’t enough slack built into the system.

Trustees were therefore left scrabbling to liquidate assets quickly to meet their collateral obligations (including the sale of their gilts, which drove the value down even further an exacerbated the issue). Not meeting the collateral call could have led to a loss of protection and damage to scheme funding positions, so trustees who were unable to liquidate quickly had no choice but to borrow cash from the scheme sponsor or elsewhere.

The Bank of England was forced intervene by embarking on a bond-buying exercise to help stabilise gilt prices. Between 28 September and 14 October the central bank purchased index-linked and long-term government bonds worth £19.3bn in its pursuit to restore orderly market conditions. The intervention had the desired outcome, with gilt yields falling materially on day one of the bank’s spending spree.

What did the regulators say?

TPR issued a statement on 12 October setting out the main points it expected trustees to be considering, with the key message being that trustees should review their operational processes and liquidity position to avoid being caught short in the event of future volatility. Trustees were also warned of the need to be able to act quickly and encouraged to speak to their scheme employers about temporary liquidity loan arrangements.

On 30 November, the Financial Conduct Authority (FCA) and the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier (together the NCAs) both made statements about the events of the preceding few weeks.

The FCA advised all market participants to factor recent market conditions into their risk management processes, and to adopt a much wider horizon of events; one which might seem extreme but is nonetheless plausible. The NCAs’ statement indicated an expectation that schemes maintain a specific level of liquidity buffer along with a reduced risk profile going forwards. TPR endorsed this expectation in further guidance published the same day.

Where are we now?

The dust has all but settled and DB schemes seem to have weathered the worst of the storm. By late November the markets had settled enough to enable the Bank of England to start selling off the bonds it acquired. But the shadow of the crisis still looms, and the industry is looking for answers, and perhaps in time, someone or something to point the finger at.

The Work and Pensions Committee (WPC) met on 14 December to discuss the crisis. The Committee relayed reports from some pension schemes that TPR placed them under huge pressure to adopt LDI when they did not think it appropriate. TPR rejected the suggestion that it dictates to or pressurises schemes or their advisers. Its role, it said, is to encourage schemes to follow TPR guidance and to manage their risks prudently. TPR also rejected the assertion that it had ignored past warnings that the liquidity crisis was a present danger.

A day earlier, on 13 December, during a webinar on TPR’s revised DB funding code, TPR’s Executive Director of Regulatory Policy, Analysis and Advice David Fairs was asked whether LDI remains a viable risk management tool in TPR’s eyes. Mr Fairs confirmed TPR’s view that LDI continues to be a useful tool for hedging some of the downside risk pension schemes face. However, Mr Fairs was careful to note that scheme liquidity buffers will need to be monitored, and that TPR will of course need to consider of any recommendations made by the WPC relating to LDI in the future.

The latest version of the draft DB funding code, published for consultation on 16 December, does still allow for LDI. TPR says that the revised code’s governance and liquidity expectations will help ensure that schemes are well placed to meet collateral calls in the future, and the industry has already shown a willingness to follow appropriate guidance. The consultation reports that the Bank of England’s intervention and regulatory statements made in October and November have already led to a decrease in leverage in LDI arrangements, and an increase liquidity buffers.

So right now, LDI doesn’t appear to be going anywhere. However we may see further guidance on or restrictions around LDI, in particular liquidity buffers and the degree to which trustees can use leveraging in LDI arrangements, the coming months. In the meantime, trustees should familiarise themselves with TPR’s latest guidance and speak to their advisers about what, if any, steps then need to take to comply with TPR’s expectations.

 

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