Increases in yields on long-dated gilts in late September and early October meant defined benefit (DB) schemes using liability driven investment (LDI) strategies needed to deal with the rapid increase in collateral required to support the LDI trades. This led to the Bank of England’s announcement on 28 September under its Financial Stability remit of the temporary purchase of long-dated gilts until 14 October.
The Work and Pensions Select Committee is conducting a short inquiry on the lessons to be learned from this experience, focusing on the impact of the recent volatility in gilt yields on DB schemes with LDI strategies and their regulation and governance. The Committee is keen to receive written evidence from those with expertise, experience or an interest in DB pensions with LDI strategies.
The effect of volatility of gilts on LDI strategy is an endorsement of LDI. This effect needs to be considered in the context of the alternative… equity markets! The highlight should be the value of LDI to pension benefits while waiting for a market recovery.
It is particularly interested to receive evidence on the following:
- The impact on DB schemes of the rise in gilt yields in late September and early October;
This is a great victory for LDI when compared to the exposure to equities.
- The impact on pension savers, whether in DB or defined contribution pension arrangements;
It is unfortunate that LDI has not been widely adopted by DC plans. The result is that benefits in DC plans have been severely compromised when compared to DB. Adoption of DC LDI requires an individualized asset allocation scheme to ensure that benefits are not squandered in arbitrary allocations (such as 60/40) or in other cases opportunities for substantially higher returns lost.
- 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;
Pension Regulators should mandate the availability of an LDI scheme for DC Plan participants.
- Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?
The existing requirement for prudence means that Trustees should make an affirmative choice to decline the use of LDI.
- Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?
The market will undoubtedly self-correct and so there are no urgent regulatory changes.
- Does the experience suggest other policy or governance changes needed, for example to DB funding rules?
No comment.
October 21, 2022
The Pension Protection Act of 2006 required that the 408(g) exemption for computer models and level fee recommendations be based on Generally Accepted Investment Theory (“GAIT”).
Since the passage of that law, the use of Liability Driven Investing (“LDI[1]”) has been generally accepted for defined benefit plans and therefore can qualify as GAIT for defined contribution plans as well.
LDI benefits investors by capturing maximum return without taking the risk of a cash shortfall or having to liquidate assets in a down market. This is achieved by segregating assets into pools based on future funding needs. Pools needed most urgently are exposed to the lowest possible volatility while pools that will not be used for several decades are invested for the maximum long-term return. In this way, long-term pools remain invested for sufficient time to recover after a market decline, while short term assets are not exposed to the decline. An important effect of LDI is reducing the temptation to sell assets during down markets.
When applied to individual investors, LDI can be reduced to just two pools, short and long-term assets. Short-term liabilities are estimated for the Maximum Planned Recovery Period (“MPRP”) which is nominally 5 years but is determined by the investment fiduciary. Short-term liabilities are updated annually. Assets remaining after funding the short-term liabilities are treated as long-term assets.
Estimates of short-term funding needs are calculated and these assets are protected from market risks. The long-term assets are then aggressively invested for maximum return.
Note that investments held in tax deferred plans are unsuitable as short-term assets and should only be used for long-term assets. Short-term assets are appropriately held in accounts with no limitations or penalties for withdrawals during the MPRP.
LDI is applied to participant directed investments:
Short-term Funding Needs
Next Year Next Year +1 Next Year +2 Next Year +3 Next Year +4 Total Needs
$xx $xx $xx $xx $xx $xxx
Total Current Protected Assets $xxx
Funding Shortfall (excess) $xxx
Long-term Assets $xxx
Computer models and level fee arrangements that elect to use LDI must meet the 408(g) baseline requirements in the following ways:
408(G) Requirement | LDI Method |
|---|---|
Age | Captured from plan data |
Time Horizons | Calculated from assumed retirement at age 65 or overridden by participant |
Risk Tolerance | Zero tolerance for protected assets, aggressive for long-term assets |
Current Investments | Calculate income currently being derived that must be replaced. Determine accessibility to meet short-term liabilities. |
Other Assets | Calculate income derived that must be replaced. Determine accessibility to meet short-term liabilities. |
Sources Of Income | Identify duration, frequency, amount |
Investment Preferences | Participant option |
November 2022
[1] The LDI theory is currently in wide use by pension funds and endowments. LDI has in large part, replaced benchmark-driven investing in these institutional funds. LDI enables these funds to meet their obligations to make payments to pensioners and beneficiaries. These obligations are the liability referred to in LDI.
By setting aside assets needed to satisfy these liabilities, the funds can make long-term investments that historically provide substantially greater returns but are exposed to temporary declines.