Written evidence from Stephen Pugh LDI0001

I am an employee, and former Finance Director, of Adnams PLC and am engaged as an adviser to the trustees of the Adnams Pension Scheme. My role is to assist trustee decision-making and ensure that external advisers are appropriately questioned.

I am writing to give evidence on the following points:

• The ongoing risk to LDI from the fact that the derivative counterparties for the inflation protection are unknown and unhedged, at least in part, by underlying inflation-linked bonds.
• The different perspectives taken by the Pensions Regulator and the Bank of England which has led to inadequate supervision of the LDI market.
• The way in which LDI has been sold to pension trustees and the question of mis-selling.

In October 2019, the Adnams pension trustees commenced an investment strategy review. The Adnams Scheme is a defined benefit scheme that closed to new entrants in 2002 and to all accrual in 2005. The Scheme advisers recommended LDI noting:

• Liability Driven Investment (LDI) offers an efficient way of matching assets and liabilities
• This is achieved through use of derivatives
• In this instance, the use of derivatives reduces the overall risk in the Fund
• Use of LDI is recommended by the Regulator & is used extensively by UK pension schemes, including by the Pension Protection Fund.

I was familiar with the idea of liability driven investment since it started to be used in the early 2000s, but the acronym LDI seems to have been commandeered to refer to a geared derivative solution which advisers refer to as being a “capital efficient” way of matching assets and liabilities.

I was interested in the way in which inflation protection could be achieved and the argument was made that as inflation linked bonds were in short supply it was better to achieve this protection through derivatives. John Plender had noted in the FT that “around £1.6tn of pension liabilities, or 70 per cent of the total, are linked to inflation. Yet the total index-linked gilt market is only around £800bn”. I was unclear who, in these circumstances would ultimately meet the inflation risk as it seemed that if inflation linked assets were in short supply to pension schemes then they would be in short supply for everyone, including those standing behind the derivatives. No one seemed willing or able to clarify who was writing the inflation protection. Primarily on this basis I advised the Adnams trustees to avoid LDI, which they did.

Whilst inflation has picked-up the market assumption is that this is a short-term issue and so there has been no major call on the providers of inflation protection to compensate pension funds for increased liabilities relating to higher inflation. I believe that this risk still exists in the market and for pension schemes to be happy using derivative-based insurance to cover inflation risk they should know who the counterparties are.

I followed-up these concerns by writing to the Pensions Regulator to ask for their view of this risk and (eventually) was told: “TPR recognises the situation you describe, namely that if there is greater issuance of inflation swaps than there is inflation supply e.g. from index-linked gilts, then there could be unmatched positions and thus potential instability in the financial system.

Our guidance to pension schemes is written on the basis that our regulatory colleagues at the Bank of England will be successful in their remit of maintaining monetary and financial stability in the UK. Therefore, we do not consider this to be a material risk to pension schemes and we do not mention it in our guidance, as you have highlighted.”

I received no helpful response from the Bank of England on raising this question with them, but I was also in discussion with various journalists at the Financial Times who told me that the Bank was focussed on the point that the derivatives were collateralised, which should contain losses should a counterparty fail.

Given these two regulatory positions, there seems to be a failure to consider the longer-term interests of pension schemes. The Regulator is disowning responsibility whilst the Bank is focussed on ensuring no immediate losses. Pension schemes on the other hand need continuing protection and if counterparties fail it is not good enough that there is no loss, there also needs to be a continuing market but neither regulator seems to be taking responsibility for this.

My final reason for making a submission is the way in which LDI is sold to pension schemes. The sales pitch focusses on “capital efficiency” – schemes can hedge their liabilities whilst maintaining what are referred to as “growth assets” (essentially equities). The suggestion is that with liability values secured, scheme deficits will be closed by these other assets increasing in value. This has indeed worked pretty well for many schemes until recently, but the assumption is that growth assets grow, but they may do the opposite and my view is that the “free lunch” aspect of this sales pitch potentially constitutes mis-selling.

November 2022