Written evidence from the XPS Pensions Group LDI0040

XPS Pensions Group welcomes the opportunity to respond to the above call for evidence, and we set out our detailed responses to the questions in the Appendix.

About XPS

XPS Pensions Group is the largest pure pensions consultancy in the UK, specialising in actuarial, covenant, investment consulting and administration. The XPS Pensions Group business combines expertise, insight and technology to address the needs of more than 1,500 pension schemes and their sponsoring employers on an ongoing and project basis. Our investment consulting team currently supports over 350 Defined Benefit pension schemes and over £113bn of assets under advice.

Appendix – Call for evidence: Responses to questions posed

The Committee would like to hear views on the following questions:

1. The impact on DB schemes of the rise in gilt yields in late September and early October.

• Impact on Funding levels – We have witnessed a wide range of client situations, ranging from those that were able to maintain their hedges through the crisis, those that had to choose to reduce them, or those that had hedges reduced beyond their control. 

As gilt yields have now fallen back to levels close to those seen before the mini-budget announcement in late September, schemes that have been able to maintain their hedging level (be it at either high or low levels of hedging) may have emerged with largely the same funding position over the period (all else being equal). Those schemes which had hedges reduced towards the peak of gilt yield spikes, will likely have experienced negatively impacted funding positions.

We would estimate that for every 10% of hedging that has been reduced at the peak those schemes funding levels would be 2% lower now as a direct consequence. For those clients that have had to reduce their hedges this has typically ranged up to 25%. In a small number of cases hedging needed to be reduced to more extreme degrees – e.g. 35% to 70% reduction.

• Near term portfolio rebalancing– with the rise of yields, LDI portfolios needed re-capitalising.  This required liquid assets to be sourced to meet collateral calls, in a short space of time.  For many schemes expected returns have now moved away from target and for some, less-liquid assets now constitute a larger proportion of the portfolio compared to their target allocation.

Schemes have been working through this to assess what action would need to be taken to rebalance the portfolio, in some cases selling down illiquid growth assets.

• Revisiting overall medium-term strategic allocation – the recent gilt market developments mean that we have now moved to a fundamentally new environment.  For LDI portfolios, leverage levels are substantially lower with more conservative recapitalisation practices.  To achieve the same level of hedging as before, greater capital must be allocated to the LDI portfolio.

This creates knock on implications for what is achievable within an overall portfolio in terms of return and risk. Schemes have been reviewing their return requirements, what level of hedging is achievable, and the level of liquidity required in light of greater margins of safety.

2. The impact on pension savers, whether in DB or defined contribution pension arrangements.

• DB pension scheme members – we expect negligible direct impact to DB pension savers given the responsibility of ensuring pensioner benefits is the responsibility of the Company, not individual. Further we note that DB pension scheme funding has generally improved since the start of the year due to rising gilt yields and is strong on average across the industry.

The disruption may have created individual cases of issues in terms of members taking transfers out of pension schemes as part of moving between DB and DC plans given the extreme swings in pricing during the period. The disruption may have had lasting impact on a small number of members who happened to be transacting during this time.

• DC pension schemes – the extent of any impact would be largely driven by which phase of the lifecycle an individual was in, however overall impact is expected to be modest.  For members approaching retirement, it is likely a large portion of bond assets would be held and they would have experienced significant temporary fluctuation in the value of their pension pot. This will have been temporary except where the member undertook significant switches of assets, where the effect could have been material. However, for the majority of lifestyle arrangements we wouldn’t expect the effect to have been materially detrimental due to the typically more gradual switching of assets that these approaches employ.

One exception would be members coming to retirement where any transactions undertaken at the time of the crisis may have suffered loss of capital value at the point of their pension being disinvested. There was a short-term dislocation between bond asset prices and stale annuity prices which could have detrimentally affected long term retirement income for any members who locked into that dislocation.

3. 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.

Given our perspective of the industry and information available at the time it is not obvious that the Pensions Regulator could have been expected to have acted differently. That said, the complexity of the liability driven investment (LDI) market and the crossover between asset management and pension risk management does highlight that there could be benefit in improved clarity as where regulatory responsibility sits in relation to LDI investments. Further we believe the industry would benefit from greater public disclosure around overall levels of aggregate hedging.

4. Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?

In our experience the vast majority of trustees have taken considerable time in past years to familiarise themselves with the rationale for LDI and sought suitable training and professional advice in setting up arrangements. This gradual learning and familiarisation process was one of the reasons why the growth in the LDI market spanned roughly two decades.

Trustees were typically well equipped to coordinate the transition of assets to meet collateral calls having established virtual processes during the pandemic. For instance, using remote authorisation procedures.  We expect the level of understanding of trustees across the wider industry will have varied between boards, depending on such things as quality of advisers and presence of professional trustees.

Whilst some exceptions may well exist, we have not observed systematic failings in terms of training or competence in relation to managing these issues. In large part governance arrangements were within what was considered at the time to be reasonable parameters. However, the processes in place were generally not designed to deal with the degree and speed of market price movements witnessed.

Whilst we are aware that some schemes have been constrained by longer term illiquidity of their assets, many schemes had sufficient liquid assets but insufficient operational processes to mobilise these assets within the exceptionally short time frames required. Whilst settlement periods also contributed to delays, we found that asset managers that had power of attorney over non-LDI assets elsewhere, or held non-LDI assets themselves, were generally better placed to manage the disruption.

This emphasis on governance factors rather than leverage was demonstrated by an observation that clients that had higher levels of leverage typically experienced relatively fewer issues during the crisis, than clients operating lower levels of leverage. Rather than being coincidence, this observation was as a result of the more stringent operational procedures that were put in place specifically due to the higher levels of leverage being run. 

These learnings have been taken on board by the industry and is being addressed in terms of reduced leverage and more robust operational procedures to replenish capital, alongside ensuring sufficient liquid assets are available.

5. Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?

We believe LDI has a vital role to play in schemes’ investment strategies. The Department for Work and Pensions’ (DWP) draft funding regulations stress the need for significantly mature pension schemes’ asset strategies to be constructed so that funding positions are “highly resilient” to changes in market conditions. We believe this still implies high levels of hedging which are likely to require schemes to use LDI in most cases.

We would agree that changes are required and the industry has been busy responding to the necessity for lower levels of leverage and improved operational procedures following the onset of the gilt sell off.

6. Does the experience suggest other policy or governance changes needed, for example to DB funding rules?

We view it that the primary learning point for the industry is recognising the greater potential magnitude of market moves in extreme circumstances and building operational processes and portfolio resilience around this extremity of stress test.

Pension scheme decision makers are cognisant of these matters and are aligned to take decisions to appropriately manage these risks.

In terms of forthcoming policy changes we have communicated our thoughts on the DWP’s draft funding regulations separately and our views expressed have not changed in light of the recent gilt experience.

We believe the experience has highlighted the importance of trustees’ understanding, portfolio liquidity and a solid operational framework more so than a requirement for regulatory changes.

November 2022