On 24 April the Pensions Regulator (TPR) published new guidance (Guidance) on the practical steps trustees should take to manage risk when using leveraged liability driven investments (LDI). The guidance replaces previous guidance issued by TPR in October and November 2022 in the immediate wake of the LDI liquidity crisis.

Background 

On 23 September the Government announced its ‘Growth Plan 2022’. It was intended to tackle rising energy costs, bring down inflation and help businesses and households alike. Instead, it caused market havoc, particularly for trustees with leveraged LDI strategies, who were typically faced with cash flow challenges in meeting margin calls and in many cases, forced to sell assets or look to the scheme sponsor for temporary liquidity solutions.

The crisis led to scrutiny from the Work and Pensions Committee (WPC), the House of Lords Industry and Regulators Committee (IRC), the Economic Affairs Committee and the Bank of England’s Financial Policy Committee, as well as a flurry of guidance from regulatory bodies, including TPR and the Financial Conduct Authority (FCA). Some of those inquiries are ongoing, but in the meantime TPR has been considering recommendations made by the various bodies involved, particularly the FPC, to produce its updated Guidance. 

What does the Guidance say?

The Guidance sets out five specific areas of focus for trustees considering investing (or already invested) in any type of LDI:

1. Investment strategy

The Guidance says that trustees should consider the benefits and risks of LDI within the wider context of their scheme and their overall investment strategy. It sets out a number of factors for trustees to assess in doing so, which largely focus on risk tolerance, liquidity and the trustees’ ability to meet payment obligations, even in stressed market conditions. 

The Guidance stresses the importance of documenting any changes to the investment strategy, and in particular recording information around things like expected risks and return, how collateral for LDI will be provided, how long that would take, and how the investment strategy meets TPR’s resilience standards.

2. Collateral buffers

The Guidance requires trustees to hold cash, cash equivalents, and/or assets as a buffer to be drawn on to meet collateral calls in the event of short-term adverse market changes. 

The buffer is comprised of two elements: 

a) Operational buffer, covering day-to-day volatility.

b) Market stress buffer, covering volatility in periods of market stress. 

The market stress buffer must be set at a minimum of 250 bps which must be maintained at all times and if drawn upon in a stress period, will need to be replenished quickly. The Guidance says that if a scheme would not be able to replenish the buffer within five days a higher minimum might be appropriate. 

There is no minimum operational buffer, but the two elements are cumulative, so if the market stress buffer is set at 250 bps and the operational buffer at 100 bps, the total buffer will be 350 bps. 

The Guidance also encourages trustees put in place a pre-agreed plan for selling assets to raise cash in the event that the buffer is too low, to enable them to act quickly and ensure a continued supply of liquid assets.

3. Resilience testing

Trustees, with the help of their investment advisers or managers, will need to test the resilience of their LDI investments and processes regularly, and in particularly where there are significant changes in market conditions or to the scheme’s funding and investment position. That testing will need to be done in two ways:

a) Testing LDI arrangements and processes against scenarios specific to a scheme’s investment strategy and vulnerabilities. 

b) Determining the degree of market movement necessary to trigger particular events e.g. the need to replenish the market stress buffer.

4. Governance

Trustees need to understand how their investment governance model affects implementation of LDI, and in particular have a clear understanding on the roles and responsibilities in respect of LDI of everyone involved in running their scheme. Those roles and responsibilities should be documented along with any processes that must be followed, discretions and limitations. The Guidance makes clear that trustees should not delegate key strategic decisions and should keep the appropriateness of any other delegations under review.

5. Monitoring

Finally, the Guidance requires trustees to establish processes for monitoring their LDI arrangements, taking into account TPR’s existing 2017 guidance on monitoring DB investments (updated in 2019).

Trustees will need to work with their advisers to establish what information they require and how often, and for some schemes TPR suggests an LDI oversight sub-committee might be appropriate.

What does the Guidance mean?

For many schemes, the Guidance won’t have a significant impact on what trustees are already doing in practice. In January, TPR reported that across the industry collateral buffers had already been increased to around 300-400 bps (from around 100-150 bps) so many schemes will have a buffer in place that complies with or exceeds the minimum requirements in the Guidance.

That said, the Guidance provides a useful summary of TPR’s expectations following a period of uncertainty in which guidance and recommendations were updated with some frequency (though the overall message remained consistent throughout).

The Guidance also makes plain that whilst trustees can and should seek advice and support from investment advisers and managers, it is the trustees themselves who bear ultimate responsibility for their scheme’s investments. That is a heavy burden for trustees to carry, but the FCA has issued new guidance to ensure that they aren’t alone. That guidance sets out the actions the FCA expects LDI managers to take to ensure the resilience of their LDI portfolios and so should have act as a regulatory second line of defence for trustees.   

What next?

The LDI saga isn’t over yet. In January TPR confirmed that it is looking at how it collects LDI data and is considering several ways in which collection might be improved, including the possible introduction of an LDI related notifiable event (an option that was reiterated by the DWP in its recent letter to the WPC).

The more immediate impact however is the delay caused by the events of last autumn to the implementation of changes to the defined benefit funding regime. Speaking to the WPC on 22 March, Pensions Minister Laura Trott confirmed that the draft regulations which form the basis of TPR’s revised DB Funding Code of Practice would not be finalised until the recommendations of both the WPC and the IRC have been published and considered by the DWP. Any changes to the regulations will then need to be reflected TPR’s revised code, and as a result that too has been delayed until April 2024.

It is also important to remember that there are two regulatory regimes at play here. Trustees are not required to follow the FCA’s guidance, but it should nonetheless have an indirect impact on schemes. Quite when trustees will see the benefit of it is unclear though, as Sam Tyfield, a partner in the Shoosmiths London Corporate team who specialises in the financial services and markets sector, explains:    

“Notwithstanding the further guidance aimed at managers, the reality is that the all-too-common disconnect between compliance and regulatory obligations of managers, contractual obligations to clients and the operations of managers' front offices, means managers will be unwilling to amend their terms of business for the present. In addition, FCA rules and guidance do not provide a direct contractual obligation to their clients: in the event of a failure by the manager to comply with the FCA guidance, the manager will be answerable to the FCA rather than the trustees or the funds directly. This will change over time, however, in the short to medium term the burden will fall heavily on trustees to monitor their funds’ portfolios and strategy; a task of which few will be capable or expected to have had the skills to undertake, let alone access to the granular detail enabling them to do so”.

It is perhaps unsurprising therefore that some industry commentators have called for more detail from TPR to better help trustees understand their obligations.