Written evidence from Ario Advisory LDI0010

Defined benefit pensions with liability driven investments

Financial risk can be a poor proxy for societal risk

We are pleased to respond to the Committee’s Call for Evidence and thank you for the opportunity to do so. Ario Advisory Is a responsible investment advisory firm. We work with asset owners (e.g. pension funds), investment managers, insurers, policymakers/regulators and others across the finance sector. We believe we can contribute helpful risk insights to the Committee’s work.

We expect that the Committee will receive a range of evidence indicating how both private sector actors and financial regulators have recently taken action, "learning from this LDI episode". We wish to go further and address the sixth bullet point where the Committee is seeking evidence:

• Does the [LDI] experience suggest other policy or governance changes [are] needed, for example to DB funding rules?

Our response is Yes, but in the context of political economy and risk governance. We recommend that the Committee reflects on Its perception of risk, and the uncertainty that lies beyond risk.

The following issue, we suggest, is poorly considered. Public policy, guided by the prevailing political economy narrative, can be poor at managing systemic risk. We rely too much on the theory of externalities, which can make assumptions that in practice are not met. We assume the culprits can be Identified, the risk quantified, and the culprit constrained. Yet governments can create "bad" externalities, systemic risks, through e.g. fossil fuel subsidy, or inadequate pandemic preparation.

The gap between societal risk management, the role of government and non-financial regulators, and the way the finance sector manages risk can be both significant and under-appreciated. We might say there is a political economy mental model gap. The private sector operates within the prevailing societal risk norms. Finance (investment, insurance, banking) treats risk narrowly. Risk management can de-emphasise uncertainty. But uncertainty is more prevalent than typically assumed.

On LDI, we understand that the Bank of England did carry out a stress test in 2018 centred on LDI liabilities. They tested against plausible 25, 50 and 100 basis point instantaneous increases in interest rates. But the recent move in gilt yields was bigger. So the stress test can be considered inadequate. Stress tests are only as robust as the stresses imagined. History can be a poor guide.

We gain insight from a risk analysis around the Bank's gilt purchases. Potential losses on their gilt operations were underwritten by the Treasury. As citizens, as taxpayers, we received a transfer of risk from the pensions sector via that underwriting of the Bank's gilt operations. So, we citizens underwrote (accepted) a new risk, but were not paid an insurance premium for that risk transfer.

Other places where this may occur, often implicitly, include the Pension Protection Fund, PoolRe and FloodRe. Government, hence citizens, are typically the insurer of last resort. We are hopeful that the CLCC, Contingent Liability Central Capability, within UKGI In HMT will devote more resources to this issue. Government can be unwilling to acknowledge this insurer of last resort role.

It may be suggested that further financial regulation should be introduced because of the LDI episode. However, it seems unlikely that financial regulation alone will address the risk gap noted above. The Committee may be aware of some House of Lords Committee recommendations around a stronger Chief Risk Officer function within government.

Early last year the Actuaries for Transformational Change group published a piece I authored: Government and its Chief Risk Officer role: an assessment – Actuaries for Transformational Change.

Consideration of this issue may go beyond where the Committee wishes to go at his stage. However, we ask the Committee to reflect at some point on its potential role in reducing systemic risk for UK citizens, especially as citizen savers.

For example, we note that this risk gap is clearly visible when considering climate change risk. As the Bank of England states in its helpful October 2021 Climate Change Adaptation report (we paraphrase): "We regulate financial risk, government policy reduces emissions." We would generalise this statement to: Financial regulators regulate financial risk; government policy should reduce systemic societal risk.

The UK DB workplace pensions sector has typically been underfunded for many years. That is a societal risk. At any point in time, its assets would not have met its liabilities. The financial regulatory environment focuses on financial risk, and in this narrow context encourages an LDI approach.

We suggest this issue may be worthy of further consideration by the Committee:

• How much societal risk (especially systemic risk) is it reasonable for the financial sector to bear, given that financial regulators have a narrower financial risk remit?

As an actuary, I have a public Interest duty. My work in this area seeks to meet that obligation.

November 2022