Written evidence from the Pension Protection Fund (PPF) LDI0031

Summary points

• Liability-Driven Investment (LDI) is an important risk management tool for defined benefit (DB) schemes – when well-implemented, it can help enable schemes to meet their funding goals and fulfil their promises to members.
• The recent crisis was one of short-term liquidity, not fundamentally the solvency of DB schemes using LDI. No schemes became ‘insolvent’, and we have not seen any claims arising as a direct result of recent volatility in the gilt market.  
• We were well prepared for recent market movements and were never at risk – we remain in a strong financial position and our LDI worked as intended. 
• The impacts on individual schemes will depend on their circumstances – while some may have been adversely affected, overall, we expect higher gilt yields will lead to improved scheme funding levels, thereby helping improve security for members and reducing risks to the PPF. 
• While we believe well-managed LDI remains a vital tool for us and DB pension schemes to manage their liabilities, it is important that lessons are learned to ensure risks are appropriately managed in future, in particular on leverage and governance.

About the Pension Protection Fund (PPF)

The PPF protects members of DB pension schemes in the UK.  In the event a sponsoring employer of a DB scheme becomes insolvent, and the scheme can’t afford to pay at least PPF compensation levels to its members, we take responsibility for the scheme and its members.

The PPF is a statutory corporation, established under the provisions of the Pensions Act 2004. We became operational on 6 April 2005.

The PPF is funded principally through four main sources:

-          Taking on the assets of the schemes which transfer to us,

-          Recovering money, and other assets, from the insolvent employers of the schemes we take on, 

-          Charging an annual levy paid by PPF eligible schemes, and

-          The returns we make from investing our assets. 

Over time we have grown significantly in scale.  Since we came into existence, we have taken on over 1,000 schemes with more than 295,000 members.  Our assets have grown over time – as at the end of the last financial year we had £39bn in assets under management (AUM) - meaning we stand among the largest pension funds in the country by AUM. 

We are in a strong financial position.  In our last published annual report and accounts, we reported a funding ratio of 137.9 per cent and a reserve of £11.7bn, as at the end of March 2022.[1]

Introduction

We recognise that the recent crisis centred on stresses in the gilts market may have understandably caused concern, particularly for the c.10 million members in the remaining 5,200 DB pension schemes in the UK.  While we wish to reassure our members and those in DB schemes of our protective role and financial resilience, we recognise the importance of assessing recent events to learn lessons for the future.

The scale and speed of the rise in gilt yields in a short time period was without historical precedent and posed significant operational challenges to some of the DB schemes we protect.  It is clear there was a genuine threat to wider financial stability, necessitating the intervention of the Bank of England on 28 September.

Given our role as the ultimate safety net for DB pension schemes, and as a significant market participant with LDI, we welcome the opportunity to contribute to this important inquiry. 

Background to our LDI approach

Before addressing the relevant points in the Call for Evidence, it might assist the Committee to provide some background on our own LDI approach.  LDI can also be known as ‘liability hedging’.

We are not a ‘typical’ pension scheme given our unique role.  However, in common with the DB schemes we protect, we need our assets to enable us to pay our members their benefit payments for as long as we need to.  The level of benefits, or compensation, we pay our members is set out in law.  These future compensation payments are our ‘liabilities’.

Our liabilities can change in value over time, particularly due to interest rates and inflation.  For instance, it’s hard to forecast whether inflation will go up or down from year to year – this is important as some of the compensation we pay to our members increases (subject to limits) in line with inflation each year.  

Relatively small changes to these measures can have significant impacts on our liabilities, and those of the schemes we protect.  As an example, we estimate that a 0.1 per cent increase in interest rates can result in a near 2 per cent reduction in the aggregate liabilities of the schemes we protect.  While this may sound modest, this equates to many billions of pounds considering DB schemes collectively have an estimated £1.1 trillion in liabilities (on an s179 basis as at 31 October 2022).[2] 

The purpose of our LDI approach is to help manage the impact of changes to our liabilities.  We do this by investing in assets (such as government bonds or gilts) which will behave in the same way as our liabilities.  Through our approach, we seek to fully hedge our interest rate and inflation risk so that the impact any changes have on our liabilities is matched by the performance of our LDI assets.

Fundamentally, LDI is a risk management tool, helping us manage our funding position and mitigate the risks from what can be significant volatility in our liabilities.  Without an LDI strategy, our assets could behave very differently from our liabilities, which may make it more difficult for us to know how much money we’ll have in future.

LDI has played a key role in our investment approach for many years and has served us well, helping us reduce the volatility in our funding position.  The total risk in any DB fund is a combination of those on the asset side (e.g. equities and credit) and those on the liability side (e.g. interest rates, inflation) of the balance sheet.  At the PPF, the Board limits the amount of investment risk we can run.  If we didn’t have an LDI programme, then a significant part of this risk budget through the years would have been absorbed in LDI risks (i.e. Inflation and interest rates).  As a result, we wouldn’t have been able to take the asset risk we have which has contributed to the significant level of reserve we have built and might have had to ask for more from our levy payers. 

Over the years, as we have developed our investment function and brought more of our investment management in-house, we have acquired significant expertise and knowledge in this area.  We are widely regarded as having a market leading LDI approach.  This expertise, coupled with our prudent approach, served us well when faced with the extraordinary recent volatility in gilt markets.  

It's worth underscoring the unprecedented and exceptional nature of the gilt market movements seen recently.  The four trading days leading up to 28 September (when the Bank of England necessarily intervened) saw three of the biggest ever gilt yield movements in a single day for which data is available.  In the prior 6-9 months, the average daily move in gilt yields might typically have been 2-3 basis points, and the previous biggest recorded increase in a day was 29 basis points.[3]  In this four-day window, there were two daily increases in excess of 50 basis points, and across the four-day period the total increase in yields was c.153 basis points.  The speed and magnitude of the yield increases were truly exceptional, surpassing anything experienced in other financial crises in recent memory.   

Impact on the PPF – financial

Despite this challenging backdrop, we were never at risk and have maintained our strong financial position.  We were well prepared for the stresses seen and our LDI strategy worked as intended.

Through our Strategic Asset Allocation, we have multiple sources of interest rate and inflation protection through physical assets.  Most of our LDI strategy is in funded instruments such as government bonds.  This, coupled with our strong financial position, enables us to lower our reliance on leverage to hedge the fund.  Consequently, our strategy has relatively limited amounts of leveraged exposure.  Where leverage does exist, we deliberately mitigate our liquidity risk by maintaining a healthy cash buffer to meet immediate margin calls (which was a key feature of the crisis) and we borrow for longer terms.  Consequently, we had plenty of liquidity to satisfy the £1.6bn in collateral calls we did face in good order without needing to sell any assets.  As gilt yields have fallen back, we have already been repaid around £1bn of this.

Furthermore, by managing our LDI portfolio in-house, we were able to react quickly, in real time, to ensure we maintained our hedge.  From an operational standpoint, a unique feature of our approach is that we re-estimate our liabilities on a weekly basis. This is a process that would normally be carried out only annually or quarterly by most pension funds.  The Investment Risk team provides independent oversight of the PPF’s liquidity risk and capacity to meet margin calls and have triggers in place that prompt action well before this capacity is at risk of becoming constrained.  All our external managers are given observable mandates to perform against, and importantly, all investment activities are fully supported by an investment operations team and integrated risk management.

Our prudent approach, coupled with our operational control and expertise, meant we were able to weather the market stresses and keep our liabilities fully hedged without needing to sell assets.  We remain confident in our funding position.

Impact on the PPF – claims

It may also reassure the Committee to note that, to date, we have not received any claims from PPF-eligible schemes as a direct result of recent events. We haven’t seen an increase in levels of early engagement, and neither has the recent dislocation in the markets been identified as a trigger to start engaging with the PPF.

While it is difficult to accurately forecast future claims on the fund, evidence to date therefore does not suggest that recent events have significantly increased our claims risk in the near-term.  Recent claims experience on the PPF has been very low, and we don’t currently expect this to materially change as a direct result of recent issues.  We do recognise that, in the medium term, a higher interest rate and inflation environment could put further pressure on some sponsoring employers, and potentially reduce the ability of some sponsors to support their schemes.  That said, the improvement in funding levels could also reduce the demands on employer cashflow required to fund deficit reduction contributions (DRC’s), which intuitively should also reduce insolvency risk, rather than add to it.  We will continue to monitor this carefully. 

It is important to reflect that the key issue which faced affected schemes at the time was one of short-term liquidity, not fundamentally the solvency of schemes.  We aren’t aware of any DB scheme having ran short of assets – instead it was the speed required to satisfy collateral calls in the form required which put some at risk of technical default on their derivative contracts and led to some having to forcibly sell assets.  We recognise that this posed significant, and in some cases acute, short-term liquidity and operational challenges to affected schemes.

Impact on DB schemes – funding

We expect the impacts on schemes will have depended on their specific circumstances. It may be some time before the full impacts on a scheme-by-scheme basis are known, for instance through the next valuation cycle.

Some schemes likely will have been adversely affected. Some may have lost some economic value through enforced asset sales in order to meet collateral calls or may have been unable to maintain their hedges (and been exposed to subsequent falls in gilt yields).  It is though likely that any economic ‘losses’ suffered on asset values may have been offset by a reduction in their liabilities.

Equally, there will likely be some schemes whose funding position has improved as a result of the move to a higher interest rate and gilt yield environment.  This may in some cases have accelerated their funding journey’s, meaning some schemes could now find themselves targeting buy out much sooner than expected.

While it may be some time before the picture at a scheme-by-scheme level is known, overall we expect that the increase in gilt yields will have a positive impact on the aggregate funding position of DB schemes.

Early signs of this can be seen in our most recent 7800 Index publications which track aggregate scheme funding on a monthly basis. In the past two months (covering September and October), the aggregate surplus of the c.5,200 DB schemes in the UK increased by c.£60 billion, up from £313.8 billion (at the end of August) to £374.7 billion (at the end of October).  This is measured on our s179 valuation basis which is broadly the cost of securing benefits at PPF compensation levels with an insurer.  Furthermore, the aggregate deficit of the schemes in deficit has fallen to £5.8 billion as at the end of October.[4]  It is though important to stress that this reflects aggregate scheme funding, and so doesn’t cover the impact on individual schemes where there could be considerable variation. 

This is still ultimately encouraging news for members of DB schemes – improved scheme funding means many members have greater assurance over the security of their benefits.

The future of LDI / lessons learned

We continue to believe that well-managed LDI remains an important tool for DB schemes to manage their liabilities.  When executed well, it can materially help schemes towards their funding objectives and reduce risks.  While we firmly believe the concept of LDI remains fit for purpose, it is vital that lessons are learned from recent events to ensure the risks are appropriately managed by schemes in the future.

We would suggest consideration could be given to:

Focus on appropriate levels of LDI leverage

Leveraged LDI remains an important means of enabling schemes to hedge their liabilities while preserving assets to invest in growth.  This can be valuable, particularly for underfunded schemes, offering them a way to close their deficits whilst managing liability risks and limiting the burden on their sponsoring employer. 

It is important though that schemes understand the risks and adopt appropriate levels of leverage – the recent crisis exposed that some schemes may have been overleveraged and not fully understood the risks they were running.  Some schemes have already sought to review their leverage and ensure they have stronger buffers to meet unexpected cash calls, which is welcome. 

Schemes running leveraged LDI strategies should have sufficient liquidity to cover appropriate stress scenarios. There could also be lessons to be drawn from the insurance industry (from where the LDI concept has its origins) where there are commonly higher capital requirements and tighter rules on borrowing.   

Improved governance and crisis management framework for schemes

It was clear that the speed and scale of market movements left some schemes unable to effectively respond at pace.  The crisis exposed that some of the features of DB scheme governance were not well suited to make real time decisions in the face of fast-moving events.  For instance, typically trustee meetings take place on a quarterly basis, and investment consultants which some schemes employ have dozens of clients (which was an issue for pooled funds). 

A strong risk framework that regularly stresses potential scheme liabilities (ie. Collateral calls) is vital and, allied to this, schemes should have a strong crisis management framework in place which enables swift decision making in times of stress or crisis.  In practice this might entail creating a small group who are able to take real time decisions.  Thought could also be given as to whether a scheme’s Chair of Trustees should be asked, on an annual basis, to sign off that:

-          The scheme has stressed any exposures that could result in future liability, such as LDI leverage, and

-          There is a crisis management decision making committee or grouping which can be convened at short notice and has the appropriate decision-making authority.  

Enabling funds to use a greater range of high-grade assets (such as gilts) to post as collateral

If there were future sharp rises in gilt yields, schemes could benefit from greater flexibility in relation to Credit Support Annexes (CAS’s).  This might have helped some schemes manage the sudden, and in some cases significant, margin calls they faced better.  Although as noted above, appropriate levels of leverage would likely have a greater impact reducing the risks to schemes.   

Capitalising on funding gains

As noted above, we expect the move to a higher interest rate environment will, overall, improve scheme funding. In some cases, schemes may have seen their positions improve markedly.  For schemes in this position, we would encourage them to consider reducing their investment risk where their funding level has improved, thereby reducing their risk and giving greater assurance to members. 

November 2022