Written evidence from the Dalriada Trustees Limited LDI0024
Dalriada Trustees Limited is responding to this call for evidence in its capacity as one of the largest professional trustee firms in the UK. We act as a trustee to almost 200 defined benefit (DB) schemes, many of which have been invested in LDI.
We hope that our evidence is useful to the Committee in making recommendations that will assist in protecting the pensions of the members of DB Occupational Pension Schemes.
We would be pleased to appear in oral evidence sessions if required.
Evidence
The impact on DB schemes of the rise in gilt yields in late September and early October
The effects of the recent LDI crisis have included:
The impact on scheme funding, but this was scheme-specific (some schemes experienced a deterioration in the funding level, some an improvement and for some, funding levels were not materially changed)
Forced sale of assets that the schemes would have preferred to retain, including haircuts on such sales and transaction costs
Dislocation of asset strategies from the sharp fall in value of a dominant asset class
Operational failures at asset managers, fiduciary managers, investment platforms, and consultants which in cases have led to losses, with litigation potentially under consideration
Poor support and advice from consultants, fiduciary managers and investment managers, as they struggled to cope with all schemes needing support at the same time
Weaknesses in data, such that trustees were unable to access accurate data on their assets or liabilities over an extended period
Likely confusion within many trustee boards who, for the first time, began to fully understand what they were invested in. A significant reason for this was the failure of consultants to fully explain the nature of the products that they had advised, possibly because of a failure on their own part to fully understand the nature of the products themselves.
The velocity in the rise of gilt yields challenged and, in some case, overwhelmed the preparedness of many DB schemes to manage this. The one way moves over a very short period triggered the issue. The operational fragility of UK DB Schemes and many of the asset managers, fiduciary managers, platforms, and consultants servicing them then exacerbated the issue significantly.
Pension funds, when not fully funded, will always need to balance hedging ratios with collateral calls and, as such, the following statement is simply not true: “pension funds can invest in illiquid assets because they are long-term investors.” The correct articulation is that “pension funds can invest in illiquid assets PROVIDED their short-term liabilities (which include collateral calls) are properly managed and the short-term book puts a limit as to illiquid investing.”
This point does not seem to have been adequately understood by some consultants who clearly did not adequately stress test their recommendations, have the resources to support the operational requirements of the situation and highlight the risks to lay trustees.
The impact on pension savers, whether in DB or defined contribution pension arrangements
No members of defined benefit (DB) schemes where we act as professional trustee suffered any interruption in their pension payments and, although members did not routinely raise concerns over the security of their benefits, for some schemes a member communication was nevertheless issued in line with the LDI statement and very helpful guidance issued by The Pensions Regulator (TPR).
That said, our response focusses on the financial impact. Another consideration is the emotional impact of the crisis. Members were worried about their pensions (especially if it is the only form of income they have) because of some of the alarmist messages in the wider press. Some members were calling in and asking about their pensions and trustees responded by providing some reassuring messages. If the LDI framework was more robust (as per all the points made in the rest of our response) then those concerns would not have arisen for members.
Several schemes where we act as professional trustee, which were in discussions regarding buy-out, have suffered a deterioration in funding positions and the potential for a secure buy-out of the schemes’ liabilities by an insurer has for the time disappeared. However, as mentioned above, for other schemes, funding levels improved and could mean that that they are closer to buy-out than before.
Regarding defined contribution (DC), the LDI crisis has demonstrated that liquidity is not a constant. Any savers trying to switch funds or cash out will possibly have been affected by lower than normal marks on risky assets. Also, the ability of funds to liquidate assets (e.g. corporate bonds) was, we understand, severely impaired. We must assume that was reflected in the Net Asset Value (NAV) of anyone exiting. It would be difficult to quantify this exactly, but DC savers were very most likely impacted.
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
Generally, yes. The Pensions Regulator (TPR) have always made it clear that schemes needed to take their own advice.
TPR’s guidance on LDI is exemplary, but we would probably prefer them to state more clearly at times that gilts plus is not the only acceptable methodology under the legislation for setting Technical Provisions (TPs).
Importantly, there was no failure by TPR in terms of its statutory duties under the Pensions Acts.
It is worth emphasising, however, that the crisis was not averted because a well-functioning system was revived. Rather, its impact was averted because the Bank of England stepped in.
Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?
For many schemes, the simple answer must be “no”.
Whilst some schemes will have glided through by virtue of their asset strategy, their advisers, their asset managers, and their governance, we would suggest a significant number of schemes that invested in LDI suffered some form of failure, and some unfortunately in more than one area.
DB pensions are a complicated asset-liability management exercise. The risks embedded are challenging for professional risk managers. The lay trustee model is not the strongest framework to hold and question advisers on risks not explicitly referenced.
Recent events provide further evidence of the need for professionalisation of trusteeship. This isn’t as simple as appointing someone who used to work full time in the industry and understands some of the technical aspects. It is about having a more institutional approach to trusteeship. The professional trustee firms need to not just employ generalists, they need to employ specialists across the key underlying disciplines and be sufficiently well resourced to manage multiple scheme issues concurrently.
Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?
Conceptually and, in particular, in the context of how pension scheme liabilities are measured, LDI is still fit for purpose, but there are lessons to be learned by product providers; in particular, in relation to pooled products.
The regulation of advice needs to be tightened up.
Also, changes are required to LDI products. Many were clearly too highly leveraged. Asset managers and consultants did not pay enough attention to the risk of rates rising so quickly and there was insufficient focus on liquidity. There have also been operational failures at both the manager and the consultant level.
There also needs to be a complete overhaul of how LDI products are advised on. There is a glaring gap in the regulation of the provision of advice on asset allocation by trustees and the use of exceptionally complex products such as LDI.
Only part of the process involved in advising pension trustees on their investments is regulated at all and often this is by the Institute and Faculty of Actuaries (IFoA) as a Designated Professional Body. We have, prior to the recent LDI crisis, made a complaint to the IFoA about a firm they regulate, and it became clear to us that they are inadequately equipped to regulate advice in this area.
We fully support the comments made by the representatives of the FCA in Oral evidence: Work of the Financial Conduct Authority, HC 142 to the House of Commons Treasury Committee on Monday 7 November 2022 and we hope those comments are acted on.
We would encourage the Committee to recommend to government that all pension consultants advising on LDI are fully regulated by the FCA.
More specifically we are concerned about the transparency of the financial models on which advice to invest in LDI products is often based as part of Asset Liability Modelling exercises. These models are very complex. Whilst there are some extremely well documented models used extensively in the insurance sector (e.g. Conning and Moody’s Analytics), we are concerned at the lack of documentation and transparency behind proprietary models used in DB pensions in the UK and developed by investment consultants. We harbour reservations that all firms operating in the industry have the resources and sophistication to develop and maintain best in class models. This area needs regulatory scrutiny because these models underpin much of the advice given in this area.
We would encourage the Committee to consider how more transparency and accountability can be achieved in relation to the financial models used by investment consultants.
The complexity of decision making in relation to LDI products is beyond the reach of the majority of lay trustees. Our view and how we organise our business is that even professional trustees are not equipped to take decisions in this area unless they are appropriately qualified (e.g. in the area of LDI, IFoA or CFA qualified) and experienced.
We do not want to appear to be self-serving, but consideration really should be given to ensuring that a pension scheme trustee boards wishing to make an investment in LDI products should, as a minimum, have an accredited professional pension scheme trustee on its board.
Ideally, further qualifications in the investment field would be highly desirable unless all day-to-day decisions are delegated to say a fiduciary manager with the required knowledge. At the height of the crisis, we were being asked to make swift decisions within hours on collateral calls – this is not the arena for unqualified/inexperienced trustees to be taking decisions.
We would encourage the Committee to consider if some element of qualification should be required of pension scheme trustees before investing in leveraged LDI or other complex products.
Does the experience suggest other policy or governance changes needed, for example to DB funding rules?
A greater focus on professionalisation is required.
There are always lessons to be learned and there is an opportunity to consider them as part of the second consultation on DB scheme funding expected later this year.
As already mentioned, regulation of advice in this area should be looked at too.
Recent events should be a wake-up call that the consolidation that can be provided by sole professional trustees managing schemes on a portfolio basis is going to be a superior model for most schemes – IF those professional trustees have ensured a highly expert, diverse and inclusive investment decision making structure.
Recommendations
We would encourage the Committee to recommend to government to ensure stronger regulatory oversight of LDI products with strong arguments for collateral stress tests to be applied at a product level. We recognise the challenges in doing this where many products are based outside the UK.
We would encourage the Committee to consider how more transparency and accountability can be achieved in relation to the financial models used by investment consultants.
We would encourage the Committee to consider if some element of qualification should be required of pension scheme trustees before investing in leveraged LDI or other complex products.
November 2022