Written evidence from Schroders LDI0041
Introduction
Founded in 1804, Schroders is one of Europe’s largest independent investment management firms with assets under management of £773.4 billion as at 30 June 2022.
Schroders has a diverse business model spanning a range of geographies, asset classes and client types. Schroders offers innovative products and solutions across its five business areas of solutions; institutional; mutual funds; private assets & alternatives; and wealth management. Clients include insurance companies, pension schemes, sovereign wealth funds, endowments and foundations.
Schroders’ Liability Driven Investment (LDI) business forms part of our “solutions” platform as well as our UK defined benefit (DB) corporate pensions proposition, albeit that it is a relatively small part of our overall, well diversified global asset and wealth management business. We estimate that our clients represent less than 10% of the total LDI market in the UK.
In the case of some clients, we take instructions from pension scheme trustees and their advisers and run the LDI portion of a wider portfolio of assets managed by other investment managers. In others, we are a fiduciary manager which means that pension scheme trustees delegate the day-to-day management of their scheme’s assets to us, enabling them to focus on strategic decision making and long-term outcomes and there will be an LDI strategy involved. In this capacity, we manage the whole portfolio, giving us an overall perspective of the scheme’s assets, not just the LDI portion. We manage both the assets and the liabilities. Where we have that overview, our experience is that the respective roles and responsibilities of the parties, including the advisers (who the trustees are required by law to consult) provides a robust governance framework, and our risk and liquidity management processes worked as intended during the unprecedented events of late September and early October.
We continue to consider the implication of those events and are committed to continuing the dialogue with regulators and policymakers. Overall, we believe that LDI strategies have served sponsors and beneficiaries of DB pension schemes well over the last twenty years, protecting sponsors from continually having to make large contributions to shore up deteriorating funding levels driven by falling yields. The benefit of LDI strategies to FTSE 100 companies is estimated to have been between £100-200bn or around 20-40% of the value of these companies’ schemes[1].
The solutions we offer to DB pension schemes have evolved over time as their needs change and will continue to do so.
We are responding to the Committee’s inquiry from our own experience, and do not purport to speak for the whole market. We have, however, contributed to, and fully support, the response from the Investment Association.
Q. The impact on DB schemes of the rise in gilt yields in late September and early October
The Investment Association and others such as the Government Actuaries Department have provided clear descriptions of the overall market impact, by which, since the end of July 2022, gilt yields have risen, exacerbated through late September and early October, with an unprecedented fall in gilts prices and rising yields.
The major investors in the longer maturities of the gilt market are UK DB pension schemes which hold gilts to match the changes in the future value of their liabilities the pensions owed to members. They also use leverage (borrow in order to invest) to also be able to invest in growth assets to generate the returns required to improve their overall funding position and bridge the gap between assets and liabilities.
Where schemes have left some of their liabilities uncovered by LDI assets, the increase in yields during 2022 has improved funding ratios because of the higher interest rate at which future liabilities can be discounted. However, the events of September and October were precipitated by rapidly rising yields, and there were concerns that schemes’ portfolios would run out of eligible collateral to pass to counterparties to cover the reduced valuation of their LDI exposures. This resulted in a negative spiral of further selling, creating additional upward pressure on gilt yields, and so created a liquidity rather than a solvency crisis. The interventions by the Bank of England were effective at halting the cycle of higher yields and further selling. This intervention allowed schemes, their advisers and asset managers the time to restore collateral positions and increase collateral buffers deemed necessary in light of the market volatility experienced.
The impact of the events of September and October has been that many schemes have increased the level of collateral held in case of further market movements of the type experienced in late September. In addition, schemes’ advisers and asset managers have sought to ensure that LDI managers can gain access to assets that could quickly be converted into deliverable collateral. In some instances, schemes have taken a strategic decision to reduce their LDI exposures rather than supply the new levels of capital now deemed necessary to support their current LDI strategy.
Where we are fiduciary manager, and can see the relevant pension scheme’s overall portfolio, our experience has been that the hedging of interest rates and inflation risks has meant that the scheme’s funding position was largely protected from the impact of rising gilt yields with their investment portfolios remaining broadly intact.
Across our fiduciary management clients we have seen funding levels improve by on average c.8% over September and October as a result of the effect of increases in yields on the unhedged proportion of their liabilities.
Looking forward we believe that the widespread improvement in funding levels is likely to have two main areas of impact.
The first is a move to insuring pension scheme liabilities which has been facilitated by a reduction in the cost of such insurance. We are working with a number of clients and their sponsors to re-evaluate their plans and accelerate a shift to full buy-out, thus providing additional security for their members.
The second is a re-evaluation of the design of schemes’ investment strategies. It will be important to be vigilant concerning continued resilience to future market shocks. This includes reviewing levels of liquidity across the entire portfolio while maintaining the integrity of the investment strategy and managing market risks, for example, by striking an appropriate balance between liquid and illiquid investments and maintaining effective diversification.
We expect most clients will continue to want to have higher levels of interest rate and inflation protection for their portfolio, achieved through hedging, so finding the balance between increasing liquidity requirements, while maintaining return expectations (i.e. allocation to growth assets) will be important.
Q. The impact on pension savers, whether in DB or DC pension arrangements
At no time were members’ pensions at risk. In fact, as noted above, due to the rise in rates, the funding levels of many schemes improved during this period. Estimates from PwC (FT, 8 Oct) suggest that pension funds moved from a £600bn deficit a year ago to a £155bn surplus.
However, as a result of the market developments, LDI came on to the radar of many outside the pensions industry for the first time. Some of the views that accompanied events were expressed without a full understanding of the background, structure and objectives of LDI, or of the governance and regulatory backdrop in which pension schemes operate. There were, therefore, misunderstandings as to the immediate impact of the market events on DB pension funds and of the overall positive contribution of LDI in recent years.
Comments about pension schemes using LDI ‘taking a hit’ or indeed ‘going bust’ did not reflect what was generally happening in the market. The events of September and October were a liquidity challenge for many pension funds, in a highly and unusually stressed market. Their solvency was not affected. The opposite in fact – the rise in gilt yields reduced deficits and potentially made them significantly more manageable. The intervention by the Bank of England was principally about maintaining stability in markets rather than protecting pensions.
More broadly, we are concerned that these events and some of the surrounding commentary may have deterred pension fund investors from continuing to save into their defined contribution pensions, potentially harming their future prosperity in retirement.
Q. Given its responsibilities 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?
We believe that the Pensions Regulator has, over time, sought to bring to the attention of trustees of DB schemes the importance of robust risk management as schemes adopt LDI strategies. We also believe that the regulator’s approach, as outlined in its letter of 10 October 2022 to the Chair of the Committee, whereby there is flexibility for trustees to invest (subject to that robust risk management) depending upon each scheme's circumstances, is the right one. It avoids the potential for creating systemic risks by imposing overly strict parameters within which all trustees should operate. The discretion of trustees, properly advised, to implement hedging based on the needs of the scheme in question is a key protection for scheme members. As the Bank of England has highlighted, and as noted above, we believe that the market events of recent weeks exceeded historical norms by such a degree that even prudent contingency planning or stress test scenarios are very likely to have been exceeded for the vast majority of schemes.
Nonetheless, in our view it is right that the Pensions Regulator should now reassess its regulation of scheme funding and governance expectations on trustees, as well as issuing new guidance regarding LDI, based on evidence and analysis of recent events, to reinforce the importance of schemes closely monitoring their liquidity risks and adopting prudent measures to manage them. We note that the Pensions Regulator, in its statement of 12 October 2022, has already provided some guidance on its expectations of trustees in light of the recent events which reflects the two focus areas (a move to buy out and re-evaluation of the investment strategy) that we outline in our answer to the first question above. We would also note that there is scope for the Pensions Regulator (along with other regulators) to impose more comprehensive mandatory reporting on schemes to enable more robust monitoring of market levels in general.
Finally, we believe that any revised regulatory framework needs to ensure consistency and cooperation across all participants in the LDI investment ecosystem, not just between the different regulators and supervisors in the UK, but at an international level.
Q. Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?
The Pensions Regulator’s guidance[2] for trustees and advisers running schemes that offer defined benefits states that before investing in any manner the trustee is required by law to obtain and consider investment advice. As a result, the schemes receive investment advice as to the appropriateness and implications of their LDI strategy. The adviser usually plays an integral part in the design of the LDI portfolio as part of the scheme’s overall strategy, selection and monitoring of the LDI manager. In this respect the investment adviser is an integral part of the governance structure and is likely to have engaged with both the trustees and the asset manager on the aspects we have raised above. As part of this process, we offer extensive trustee training to help ensure that the concepts and practical aspects of LDI are understood by our clients.
As noted in our introduction, our LDI services are offered in such a way that we are either required to take client instructions with respect to, say, increasing a scheme’s liquidity, or we operate as fiduciary managers where the trustees delegate to us the day-to-day management of the scheme’s assets (while they retain the high-level strategic decision-making). In either case, the client’s LDI exposure may be achieved through a segregated mandate or through pooled funds. Our experience has been that the governance arrangements for each were robust and operated successfully overall.
Whatever the nature of the legal relationship that we have with our clients, we seek to work with and support trustees and their advisers in designing their investment strategy and understanding the risks involved. We also provide extensive training, including specifically around LDI. We aim to provide analysis that enables our clients and their advisers to decide on their overall risk appetite in light of how funding levels will be affected by changes in gilt yields, the magnitude of the risk relative to other risks in the portfolio and the strength of the sponsor covenant. This should enable them to understand the implications of the LDI strategy for the rest of the investment strategy (such as capacity to invest in return seeking assets and meet collateral requirements) as well as to consider the investment and operational risks associated with using an LDI strategy.
Once implemented, trustees receive reporting that enables them to regularly assess how well the hedge is tracking the chosen liability objective, and to challenge our investment teams on any apparent variations from expectation. Importantly, this reporting is graphical as well as numerical and so does not require them to be experts to be able to identify when the performance is not as expected.
Trustees also have a responsibility to ensure that appropriate processes and controls are in place to manage the operational risks arising from the use of leverage in the LDI strategy. The two primary operational risks are derivative counterparty risk and liquidity risk management. As with the review of the overall strategy, the regular reporting provided to trustees should enable them to govern this effectively.
Where trustees appoint a fiduciary manager, they should expect the additional protection and governance benefits of using the fiduciary manager’s professional skills in the initial and ongoing assessment of these risks, as well as the assessment by a single manager of the full portfolio’s liquidity on an ongoing basis. A fiduciary mandate should provide trustees with professional day-to-day liquidity oversight and governance across the full portfolio and clarity of responsibility – and access to assets - to promptly take action and make portfolio changes when needed to augment collateral availability. In our view, fiduciary management was proven to provide a robust governance structure during the market events of September and October.
Q. Whether LDI is still essentially “fit for purpose” for use by DB schemes? Are changes needed?
The recent challenges will rightly lead to questions about LDI strategies, and it is important to learn lessons. Nonetheless, we continue to believe that LDI has and will continue to offer more benefits compared with the alternative of DB pension schemes not hedging the interest rate and inflation risk inherent in their portfolios.
The principal lesson from these events is that the availability of assets that can be used as collateral for the LDI exposures is key. This may mean that schemes will need to hold more gilts and cash as the first line of defence against market moves and have an increased focus on the liquidity of other scheme holdings going forward. We believe that large allocations to illiquid assets are incompatible with leveraged LDI programmes if there is a foreseeable risk of there being insufficient liquidity to support the liability coverage as a result.
Increasing collateral buffers creates more time to sell other assets to continue to support the hedging strategy if interest rates rise. Nonetheless, no matter how much collateral a scheme holds, if yields shock up by a big enough margin, and in a short space of time in excess of those expected by the buffers calculated in the LDI strategies, it will be eroded. As with other types of investment risk, it can be managed but not eliminated.
Q. Does the experience suggest other policy or governance changes are needed, for example to DB funding arrangements
In summary, we believe that the main lessons to be learnt are:
November 2022
[1] Source: Steve Hodder, Lane Clark & Peacock November 2022. https://www.linkedin.com/posts/steve-hodder_ldi-gilts-investments-activity-6993895274670653440-Ov_D?utm_source=share&utm_medium=member_ios