Written evidence from Agewage LDI0007

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

I live with the CEO of a large DB plan which needed to liquidate a large proportion of its equity holdings and seek a line of credit from its sponsor, the crisis was more than notional, much of the money posted as collateral won't be seen again, the assets of the scheme are depleted and much money has been spent in the liquidation process. I understand the scale of the collateral call ran into billions of pounds.[1] 

Here the scheme knew the problem and was able to manage it through internal resources. I know too of small DB schemes invested in LDI pooled funds that were blind to their problem and found their hedges taken from them without consent. They have lost the protection of the geared  LDI and find the value of their pooled fund holdings much reduced. These schemes have suffered more proportionally because they had no means to manage the problem and became sitting ducks.

- The impact on pension savers, whether in DB or defined contribution pension arrangements;

Defined benefit pension scheme savers have been put to worry but are protected from the consequences of technical insolvency by the technical reduction in liabilities, should gilt yields revert to former low levels, the depletion of assets will leave them less secure.

Many workplace pension savers, especially those in legacy DC pensions are stranded in pre-retirement funds which are invested either in long dated or index linked gilts or in corporate bonds. This is a result of "de-risking" when their scheme has swapped growth for defensive assets - typically their funds have lost between 20 and 25%. They have been told they are in risk-free funds, and they get a nasty shock when they discover their savings have gone down at a time in their careers when they can't make up the shortfall between the funds they anticipated and what is left.

- 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;

In my opinion, the Pensions Regulator insistence on de-risking to buy-out or"self-sufficiency" from the sponsor and full funding against a mark to market accounting standard has increased the dependency on geared LDI which has led to 2/3 of corporate DB schemes using this approach. The stress testing done with the Bank of England in 2018 was inadequate, testing to only a 100bps spike in yields. The result of the Pension Regulator's heavy-handed approach to risk is clear to see. It got carried away with one set of risks and got blind-sided to another.

The question of whether LDI is a legal means of investing for the longer term is a difficult for TPR. The original idea was that low interest rates were a short term aberration rather than BAU. When LDI was implemented in the noughties it was considered tactical but when it became a strategic part of scheme investments TPR tacitly legitimised gearing as a means of improving long term returns. This was ill advised as it allowed trustees to consider LDI an acceptable set and go product. As it turned out - this was a disastrous misconception.

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

Trustees will look back with regret, but sponsors will look back with anger. Sponsors will end up paying yet more deficit contributions if gilt yields revert to below 3%,

It could be argued that Trustees were right to trust the Government not to be so stupid as they were and that they were let down. I don't subscribe to this view. 

Trustees were led down the geared LDI route by their advisers but found it only too easy to say "yes" to a strategy they would not have considered in other areas of business. LDI was a convenient way for an easy life, but many trustees refused the easy way and did recognise the risks. 

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

Geared LDI is a crutch that many schemes will still lean on. A recent LCP seminar suggested that most schemes hope to keep their hedges in place for a variety of reasons, but sentiment is now moving away from illiquid strategies ; change will be driven by providers unwilling to to keep geared positions in place as well as from trustees once bitten twice shy.

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

The question that needs to be asked is "why LDI was necessary?" and the answer is because of the accounting standard introduced in 2004 requiring funding to be accounted for on a mark to market basis. So long as this approach persists, funding pressures on schemes will drive them towards continued use of LDI strategies.

Adopting a longer-term approach to funding that does not require the mark to market approach would reduce the risk of this problem happening again.

November 2022