Written evidence from Andrew Macpherson LDI0003

I am a semi-retired pension scheme liability driven investment portfolio manager. During my career I have also been a pensions actuary, investment consultant, and fiduciary manager. I stopped being a portfolio manager c18 months ago so my knowledge of liability driven investments and their interaction with pension scheme assets and liabilities is based on the current DB regulation regime. Most of my experience is with multi-billion pound DB pension schemes but I have also worked with smaller schemes. I have also been involved in some of the largest captive insurance and insurance buy in transactions entered into by UK DB pension schemes. Given the expected number of replies I have tried to focus on a few specific points raised in the call for evidence but would be happy to expand on if asked.

The impact on DB schemes of the rise in gilt yields in late September and early October

Most DB pension schemes were in deficit on their target funding basis before yields rose. For the majority of pension schemes with well-run LDI strategies and access to sufficient cash to meet margin calls from rising gilt yields their funding position and/or deficit in £m will have improved. However, a minority of schemes may have suffered serious harm if they did not have sufficient assets to meet margin calls and were forced to close out liability management trades at disadvantageous prices when the gilt market was not functioning efficiently. This may have been a particular problem for smaller pension schemes who accessed liability driven investments via leveraged pooled funds (funds that bought more market exposure than they had assets) if they could not meet capital calls from these funds.

Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?

Trustees did not sufficiently understand the liquidity risk (risk of not having available assets to meet margin calls despite having enough assets to meet their liabilities in the long term) in the liability driven investment strategies promoted by investment consultants and asset managers. When questioned about these risks the standard answer from most investment consultants was along the lines of “The Repo market (used to get cash to meet margin calls while maintaining economic exposure to government bonds) is the deepest and most liquid financial market in the world”. Pension Trustees were not made aware that when there is a large change in government bond prices and/or issues around counterparty (who you trade with) risk this market ceases to function well as was seen in the 2008 financial crisis. This is not necessarily a failure in the governance arrangements, but in the investment advice given to pension schemes.

Given its responsibility for regulating workplace pensions, whether the Pensions Regulator has taken the right approach to regulating the use of LDI and had the right monitoring arrangements

The primary issues were in investment management products which pension schemes were advised to use by investment consultants and run by FCA regulated asset managers. Regulation of these areas probably belongs to the FCA not the Pensions Regulator.

Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?

LDI can still be fit for purpose for DB schemes, however without a few changes in how LDI strategies are run in it is only a matter of time before they are impacted by another liquidity crisis.

1)      The key change which would be to increase the range of collateral used to margin liability driven investment hedging strategies. This would be a reversal of the trend towards only using cash to margin positions which suits banks and asset managers but increases liquidity risk for DB pension schemes. Insurance companies were significantly less impacted as their regulation encourages long term liability hedging contracts (rather than short term hedging which has to be replaced or “rolled” every few months), and the ability to use securities such as government bonds as margin payments rather than just cash.

With compulsory clearing of many DB pension scheme derivative contracts due to come in next year, the biggest single mitigation would be to set up access from the clearing houses to the Banks of England to act as a Repo of last resort (at penal rates to discourage regular use). This would allow clearing houses to take government bonds as well as cash as margin payments and significantly reduce the risk of a self-fulfilling spiral higher in Gilt yields as seen in September/October.

2)    Regulation of the leveraged (they buy more exposure than they have assets) pooled LDI funds used by smaller pension schemes needs to be reviewed. These were the main pressure point in the recent sell off, and my understanding is that many of these funds could have been forced to liquidate investments held due to cashflow timing issues (not solvency/access to cash) without intervention. Regulation needs to be put in place to ensure that the timing of the liabilities (effectively cash out in margin payments) of these funds matches their access to cash from the investors into these funds. The location of this regulation may be challenging as most of the pooled funds are set up as Irish structures, but it should probably fall to the FCA if marketed to UK pension funds.

Does the experience suggest other policy or governance changes needed, for example to DB funding rules?

Current DB funding rules incentivise pension schemes to invest in Gilts and similar quasi-UK government debt. This is not necessarily a problem, however policy makers should be aware that this creates a concentration of risk around UK government debt which will impact private pensions as well as state pensions should the UK government ever default or get close to default on its debt.

November 2022