Written evidence from Aon (LDI0025)
Aon is pleased to submit its response to the Work and Pensions Committee’s call for evidence on Defined Benefit pensions with liability driven investments.
Aon is a leading global professional services firm providing a broad range of risk, retirement and health solutions, with more than 50,000 colleagues in 120 countries. We work with the trustees and sponsors of around 1,000 UK pension schemes. Globally, we work with more than 2,300 clients with assets totalling $3.8 trillion.
We comment on each of your particular areas of interest below.
The sharp rise in yields meant that schemes that were managing their interest rate and inflation risk through using leverage were required to top up collateral with the fund managers who were managing this risk on their behalf. The speed of the yield increases meant that collateral was required to settle with the manager more quickly compared to the normal timescales that managers worked to. Typically, schemes would not normally be fully hedged and therefore to the extent they were underhedged, the rise in yields would have had a larger impact on reducing liabilities than assets, benefited the scheme with higher funding levels. The issue was with regards to liquidity rather than solvency of pension schemes.
The impact on pension savers, whether in DB or defined contribution pension arrangements
With regard to pensions savers in DB pension arrangements, there is no direct impact. The underlying funding levels will have been impacted but the magnitude will be scheme specific depending on the level of hedging.
Schemes with low levels of hedging will potentially have seen large increases in funding levels while fully hedged schemes will have seen funding levels remain constant. In some circumstance, schemes may have had to reduce hedging immediately before the Bank of England’s intervention resulting in worsening funding positions, as yields subsequently rose increasing liabilities.
For members of DC pension arrangements, the impact will be dependent on their underlying strategy and whether this had an allocation to gilts. We expect the vast majority of DC pension savers to be invested in default strategies (lifestyles or target date funds) - which largely target drawdown in retirement. Many of these investments may well have allocations to gilts for those who are closer to retirement and the impact will be dependent among other things on the size of the allocation/how well diversified the strategy is and the length of the de-risking period. There are fewer schemes that are still targeting an annuity at retirement through these strategies and the allocation to gilts would typically be higher in these cases. However, falling gilt yields will also lead to lower annuity prices. There is less concern for members further away from retirement in these types of strategies as most are heavily weighted to growth assets and so have longer to go until retirement to make good any losses.
The Pensions Regulator has stated that “Trustees may wish to consider LDI to enable them to better manage the interest rate and inflation risk within their schemes.” In the guidance it highlights that using LDI does introduce additional risk that Trustees should understand and manage appropriately. Every scheme is unique and therefore it is difficult to set defined rules on regulating the use of LDI given the interaction of LDI with the wider investment strategy and liquidity profile. The level of monitoring has been adequate in recent years however pension schemes should prepare for enhanced monitoring of hedging and liquidity profiles in periods of significant volatility.
The governance structures in place were tested over this period with Trustees having to make quick decisions given the speed of market moves. Governance structures that had delegated management to our fiduciary managers or schemes with in-house investment teams generally held up well. On the whole most pension funds we observed ended up in the position they intended. The level of understanding by Trustees of risks associated with LDI was mixed, with professional Trustees having a good understanding of the risks and other Trustees understanding dependent on when they had last had some refreshed trustee training in this area.
The fundamental principles behind LDI are fit for purpose but as with any strategy this will need to evolve given the increased volatility witnessed within the gilt market. The sudden rise in yields resulted in a liquidity issue rather than solvency and therefore overall DB scheme investment strategies will need to change to recognise the increased need for liquidity within LDI strategies resulting in lower levels of leverage being used. Schemes may choose to amend portfolio allocations including targeting lower hedge ratios or investing less in illiquid assets.
Our view is the proposed legislative changes currently in the pipeline could exacerbate some of the issues discussed above. Our comments below reiterate points we made in our response to the DWP’s recent consultation on the draft Occupational Pension Scheme (Funding and Investment Strategy and Amendment) Regulations 2023, on 14 October.
We have flagged concerns around rigidity of proposed legislative changes and highlighted the consequences that these changes would bring forth, including less flexibility to adapt to changes in market conditions and possibly forcing schemes to adopt similar strategies and having to take less riskier strategies that would otherwise be beneficial in addressing risks such as longevity. Concern over the direction of travel for the new funding regime has been echoed by a large proportion of market participants (c. 80%) in a recent client webinar we conducted on the 26th September.
November 2022