Written evidence from Simon Willes LDI0014

This Enquiry calls for evidence regarding the impact of LDI on pension savers which is the focus of this submission. My specific area of expertise is integrated risk modelling (“IRM”) of defined benefit pension schemes and I have led the development and commercialisation of this type of modelling which seeks, inter alia, to assess and quantify the overall benefit security which DB schemes provide to their members. Benefit security is the key yardstick through which to measure the impact of risk management and policy in DB pensions - yet it isn’t currently being measured. IRM is needed to measure it.

The actual longer-term benefits to members of DB schemes of Liability Driven Investment policies is far from clear. The major actuarial consultancies have been selling LDI to their clients since the last financial crisis in 2008 and LDI has become a significant profit contributor to their businesses. LDI has been a key driver for DB investment de-risking: a trend which has been extensively documented and described by some commentators as “herding” and in its extreme form results in DB schemes all wanting to buy, hold and sell the same assets at the same time creating potential for financial instability.

Integrated risk modelling demonstrates very clearly that investment de-risking, for all but the most secure schemes, may have had far less benefit to members than was advertised by investment consultancies, and for many weaker schemes may have actually reduced benefit security. This is because investment de-risking slows down funding progress which results in risk being transferred to the employer covenant- meaning a much longer period of exposure to employer insolvency and real risk to benefits. The overall impact depends on how risky the employer covenant is. Everyone has missed seeing this extremely important risk relationship. If they had understood it then the “herding” pressure into index-linked and longer-dated gilts would have very likely been materially less. To explain to the PSC how this “risk transfer” works a short precis of the explanatory session I did for the Association of Consulting Actuaries Conference in September 2022 is appended.

This “risk transfer” of investment risk to employer covenant risk now needs to be properly acknowledged and recognised. The recent spotlight on issues caused by LDI is the right point in time to do so. It calls into question why LDI and investment de-risking was pushed so strongly by consultancies to their clients and why the Pension Regulator and the PPF have encouraged wholesale de-risking through regulatory guidance and case work. This may prove both uncomfortable and inconvenient.

Expunging investment risk and locking down the current value of long-term pension liabilities through LDI has very likely reduced funding progress by DB schemes in the period 2008-2022. This was real funding progress reflecting the impact of investment returns on scheme assets and not funding progress reflecting the effect of interest rate expectations on the “value” of potential future liabilities. Fortunately the risk transfer from investment risk to employer covenant risk coincided with a relatively benign period for employer insolvencies (likely reflecting the artificially low cost of servicing bank debt accompanying quantitative easing) but that is now changing and the full cost of LDI will emerge in the form of schemes entering the PPF with deficits that might otherwise have been avoided or reduced to a lower level. The impact on members of these schemes will be the potentially material reduction in benefits to PPF levels of benefit and of other schemes a greater period of uncertainty before benefits can be insured or otherwise secured through consolidation.

In conclusion it is really important that the impact of LDI and investment de-risking on overall member benefit security is assessed and measured by those consulting and advising on it. To do this requires integrated risk modelling and without it DB schemes and their trustees are not being properly informed of the potential consequences of LDI and de-risking. In addition the regulatory stance on investment de-risking needs to be adjusted to judge how investment policies of DB schemes are being set by their impact on the overall security of members benefits, accepting that sometimes obtaining investment returns may be more important than supposedly eliminating investment risk.

Appendix

How investment de-risking could just be transferring risk exposure to the employer covenant:

Are we are seeing the whole picture when investment consultants and others prescribe de-risking as a universal virtue?

The benefits seem very obvious- reduced VaR, reduced deficit volatility and the use of matching assets to hedge economic exposures. From the scheme actuary’s viewpoint de-risking facilitates a stronger funding basis through a reduced discount rate, a more certain funding trajectory, and the introduction of LDI. If the scheme is in TP deficit territory, then additional employer contributions will be needed to repair any increased deficit. From the covenant adviser’s perspective there is no obvious short-term impact and the point in time integrated metric (liked by tPR) of net cash flow/1 year VaR improves.

What we are not seeing is that de-risking slows down funding progress…with lower average returns it takes longer to get from today’s funding level to a target safe funding level of choice whether self-sufficiency, low dependency or insurance. And slower isn’t just a few months but years because returns are usually by far the biggest driver of funding progress.

The mechanism by which investment risk can transfer risk exposure to the employer covenant is through slower funding progress. DB schemes are like children- they are financial dependents. In DB the time period and level of financial dependency is defined by funding progress towards a safe target funding level or endgame- the safest being solvency funding. The members of DB schemes can only lose promised benefits when the promise is broken through employer insolvency. Loss of benefits is the most serious risk DB scheme members face and the risk of employer insolvency accumulates over time evidenced by a huge amount of data from credit and banking markets. To recap de-risking slows down funding progress, increases the time period of a scheme’s financial dependency on an employer and thereby the risk of experiencing employer insolvency- which opens up the potential for members to lose benefits.

So why didn’t we see this happening? There are several reasons: accountancy focus on covenant is short-term and misses the scheme lifecycle build-up of employer default risk; regulatory guidance on covenant focuses on point in time immediate worse case outcomes rather than the probability of experiencing a worse-case outcomes in the future; and actuaries and investment consultants only measure their respective pieces of the risk jigsaw and not overall benefit security. We therefore need to avoid making this mistake by evaluating the “trade-off” or “transfer” of investment risk to covenant risk if our investment policies are to withstand integrated scrutiny. We need to understand how the balancing act between reduced exposure to poor investment outcomes and increased probability of employer insolvency works out in different contexts.

An integrated risk model such as DBiCAM© can output “member outcomes” probabilistically and this provides an easy to use first level check on the impact of de-risking. Member outcomes allow users to visualise endgame development, understand longer-term covenant risk and then re-consider investment policy. Advanced integrated risk modelling, which we used with the BT Pensions team for their last valuation, takes things further examining a wider range of integrated risk impacts on members, scheme and employer of de-risking flight paths under a variety of conditions.

This modelling challenges the standard diagrammatic of integrated risk management like the one in tPR’s IRM guidance. The risk map which emerges from integrated risk modelling is one of primary dependency on covenant with secondary risk influences from scheme funding level and maturity. Using this new diagrammatic it becomes a lot easier to see how investment policy and covenant interact and how appropriate de-risking is likely to be for a particular scheme context. The more imperfect the covenant the less appropriate and more potentially damaging de-risking is likely to be.

We should be taking a much more critical look at de-risking. Yes potentially it is beneficial, particularly for schemes with strong covenants, but a lot of the time the benefits of de-risking are over-stated because it is transferring risk onto covenant and everyone has been missing it - and de-risking too quickly may actually harm benefit security. If you are doubtful about hearing this from someone who is not a qualified actuary take a look at some eminent actuaries acknowledging most of this in the BAJ (The End Game & Beyond, September 2021) under the auspices of the IFoA.  However they don’t yet have an integrated risk model with which to investigate the impact of de-risking.

November 2022