Written evidence from Lane Clark & Peacock LLP LDI0049

About LCP

LCP is a firm of financial, actuarial, and business consultants, specialising in pensions, investment, insurance, and business analytics. We have over 800 people in the UK, including 150 partners and over 200 qualified actuaries.

LCP has over 700 pensions consultancy clients, including:

• over 250 Scheme Actuary appointments, of which 25 are in respect of schemes with assets in excess of £1bn; and
• over 300 investment appointments, of which 29 are in respect of schemes with assets in excess of

£1bn.

Our client list is diverse and includes nearly half of all FTSE 100 companies. The provision of actuarial, investment, covenant, governance, pensions administration, benefits advice, and directly related services, is our core business. About 85% of our work is advising trustees and employers on all aspects of their pension arrangements, including investment strategy. The remaining 15% relates to insurance consulting, energy consulting, health analytics and business analytics. LCP is authorised and regulated by the Financial Conduct Authority and is licensed by the Institute and Faculty of Actuaries in respect of a range of investment business activities.

Thank you for the opportunity to submit written evidence to this important inquiry. Our responses to your questions are as follows. This response is c3,000 words in total.

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

At the time of writing gilt yields are now back at a similar level to the beginning of September, and are substantially higher than they were at the start of the year. We discuss below the impact of the late September / early October rise (and subsequent fall) and place in the context of the overall rise in rates during 2022, as all of these components we think are relevant in understanding the impact.

We believe that a majority of schemes will have seen little negative impact and are likely to be in a better funding position in November 2022 than they were at the start of the year.

Among those schemes impacted negatively we think there are three broad categories and that in reviewing the event it is important to understand these individually:

1.       Some schemes, which we believe (based on schemes we work with and others we have sight of) to be a small proportion, had their hedges forcibly reduced in the days immediately prior to the Bank of England (BoE) intervention or the days shortly after. This came about in one of two ways, firstly the manager may have made a decision to reduce the hedging as available collateral fell, or secondly the scheme may have been unable or unwilling to meet a collateral call, leading to the manager reducing the hedge.

• Where hedging was not subsequently re-instated these schemes would have since suffered a fall in funding level, as they would have had a lower hedge ratio as yields fell following the BoE intervention and political changes (falls in gilt yields typically lead to higher value placed on liabilities, and with lower hedge ratios asset values would not have risen as quickly). Albeit this exposure remains open and they may regain some of these losses (or make further losses).

• Where hedging was reinstated, the impact depends on the timing of the hedging being taken off and put back on. Some of these schemes will have crystallised a loss (eg if hedging was taken off immediately prior to BoE intervention, then reinstated shortly afterwards). Others may not have.

2.       The second category of impact is some schemes that made their own decision to reduce hedging at some point, and have not subsequently re-instated the hedging. This decision was usually taken given low levels of collateral available (in the context of the short time periods required) and the expectation of more volatility ahead in gilt yields, as well as asset managers requiring larger collateral buffers.

• This would have likely had a negative impact on the funding level as yields have since fallen.
• This also has the effect of exposing these schemes to more interest rate and inflation risk going forward.

3.       Finally, a larger number of schemes would have had their asset allocation disrupted and find themselves out of line against their target investment policy allocations. The magnitude of this impact will vary from scheme to scheme:

• Some schemes with meaningful allocations to illiquid assets will have seen these allocations rise as a proportion of their total, potentially above their strategic targets. These schemes may need a period of time to rebalance back to their preferred asset allocation potentially incurring transaction costs.
• Some schemes will have needed to sell assets to meet collateral calls in a short timeframe. They may have sold these at depressed prices or incurred higher than usual trading costs.
• Some schemes will have faced a steeper trade-off between risk management through LDI and investing for growth given the requirement for lower leverage in LDI going forward. Schemes may have chosen to reduce their prospective returns, reduce their hedging or a combination of both.
• Some schemes may have faced acute short term liquidity needs in meeting collateral payments and a few have taken out (short term) loans from the sponsoring employer to support the transition to a rebalanced portfolio.

However as previously indicated, many schemes, including many that suffered from some of the above adverse effects, are likely to be in a better funded position than before 2022, and indeed in the best funding position they have ever been, particularly if looking at the £ amount shortfall to fully securing members’ benefits with an insurer.

Where (a minority of) schemes are now less well funded, they will continue to look to their sponsoring employers for support (as envisaged by the statutory scheme funding regime and they would do in any event, and have done for many years following any investment losses that occur from time to time).

The impact on pension savers, whether in Defined Benefit (DB) or Defined Contribution (DC) pension arrangements

• The impact on DB pension savers of market developments during 2022 is likely to be minimal or positive on average – schemes are overall better funded (there is a currently a boom in insuring pension schemes, caused by the market movements in 2022, which is better for members – more details on the current market for de- risking transactions can be found in our recent report1) and companies stand behind schemes, so pension security is not likely to have been adversely affected in most cases
• Movements in gilt yields impact DB transfer values for members. Transfer values have fallen during 2022 albeit gilt yields are at the time of writing at similar levels to before the mini-budget. We would also note that taking such a transfer is an option for members and they are not compelled to take it. Regulation also requires many members taking a transfer value to receive advice from third-party financial advisers, who are independent of advisers to pension schemes.
• For DC savers, the biggest impact has been on those members approaching retirement and hence, have little time to recoup any losses. While generally markets have not been favourable to these members during 2022,

1  https://www.lcp.uk.com/pensions-benefits/publications/future-demand-buy-in-buy-out-market/

those most affected will likely be those invested in pre-retirement funds that are designed to match annuity pricing as these typically invest mainly in longer dated gilts. For this smaller minority:

• The price of annuities also moved in line with gilt yields – so that the price of annuities has tumbled as gilt yields have risen. Thus “net/net”, members may not be worse off if they are buying an annuity. However, that can be a difficult message for members.
• The key issue is where savings were realised during the period late September / early October and not used to buy an annuity. That would be where one would see the greatest potential impact on individuals – a mismatch risk.
• We note that 30 September is an important reporting date and unit prices at this date will have driven reported balances – hence members may express concern or complain at the alarming size of the falling value of their savings.

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

We think it’s vitally important here to separate the issue of systemic regulation of the DB pensions universe as a whole to the specific regulation of individual scheme risk management activities – these are two separate roles and ought to be evaluated independently. There has been plenty of focus on schemes’ individual risk management and we comment on this below in the context of your question on understanding and governance. We think the systemic angle has been underappreciated. Our thoughts on the systemic point are:

• It is widely recognised that the responsibility for managing systemic risks cannot fall primarily on the market participants. For example, it falls on governments and regulators to manage the banking system to minimise the risk of a bank run happening. It is then generally considered reasonable for market participants to assume that they are operating in a reasonably stable system, governed sensibly by central regulators.
• We would note that TPR does not have a market based systemic element to its objectives. (The Bank of England and the FCA both do.)
• One systemic function that TPR can perform is collecting and reporting of industry-wide data. Through the annual Scheme Return process TPR obtains the best dataset on how DB pension schemes are allocating their assets and how their assets perform in stressed environments. However, it is clear that this data is lacking the information that really matters when it comes to LDI – namely reliable and up to date information on leverage. This can be seen from the comments made in TPR’s letter to the committee in the approximate nature of the numbers given, and no information on leverage and buffers. This is also evident from the nature of the data schemes are required to give in the scheme return.
• The Bank of England’s 2018 Financial Stability Report2 included a study into the risks of leverage in the “non- bank” financial system, which is primarily leveraged LDI in pension schemes. This study (see pages 51 to 57) was conducted with TPR and FCA and makes interesting reading. The key points we would note are as follows.
• First, it is clear that the Bank of England, working with the other relevant regulators (the FCA and TPR) accepts responsibility for systemic risk. That is why they conducted the study in 2018, reaching the conclusions they did. The FCA has an objective of making sure “the relevant markets function well” and the Bank has a financial stability objective.
• Second, in the report the Bank describes a scenario test it conducted based on a 1% pa upward movement in gilt yields, concluding that pension schemes could cope with that impact. This is described as a 1-in-1000 event over one month. It is interesting to note that, ignoring systemic risk, that may well be a reasonable assumption and indeed is broadly consistent with the levels of market volatility many LDI funds were designed to comfortably withstand. But, in hindsight, systemic risk

2 Report https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2018/november-2018.pdf

contributed to movements much greater than this in late September 2022, and it would be helpful for all market participants to note this.

• Third, they helpfully concluded that “Data currently reported to the supervisors [ie TPR] of non-banks [ie pension schemes] do not include all the information needed to monitor the risks appropriately. The Bank will work with other domestic supervisors — the PRA, FCA and [in the case of pension schemes] The Pensions Regulator (TPR) — to enhance the monitoring of these risks”. They also conclude that “If it is found that risks reach systemic levels, further action should be considered [presumably action by them and their fellow regulators]”.
• We also note that TPR has limited regulatory influence on scheme investment strategy and does not (and is not able to) make specific and binding requirements of schemes in terms of their investments. TPR industry- wide comments on investment tend to be worded as broad guidelines.

In conclusion, having separated systemic risk from the specific risks of individual pension schemes we think robust systemic regulation requires regulators that have: the mandate, regulatory influence, and relevant information to fulfil a systemic role.

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

• We don’t think a lack of governance and understanding are key drivers of what happened in LDI in September / October 2022. In our view it was the unexpected speed and magnitude of gilt yield rises that caused challenges. Most governance arrangements reacted well to these market events.
• It is hard to answer concretely and definitively on the question of understanding even for a small group of people. Our client base is hundreds of schemes and thousands of trustees (the DB pensions universe is 5,000 schemes and tens of thousands of individuals).
• We think two points are key to pull out and we can have reasonable confidence on these for our client base:
• Did trustees understand conceptually that LDI was levered? We think they did – this was a key part of our training in all cases and was frequently an area we would be questioned on by trustees. Hence we can be quite confident that trustees understood that LDI was levered.
• Did Trustees understand the mechanics of LDI that required more collateral to be posted if rates rose? Again we can be quite confident that our client base did understand this because:
• The amount of collateral remaining (and the yield rise buffer this could sustain) was and remains a key metric that clients report in quarterly monitoring dashboards by investment managers and ourselves, and is a key metric considered in any investment strategy decisions (particularly when making allocation to more illiquid asset classes)
• We spent a considerable amount of time with clients over prior months and years making plans to replenish collateral involving substantial discussions of the amount of collateral required and what-if scenarios regarding rates rising
• So, while it is impossible to answer definitively on an open-ended question around understanding of LDI we can be quite confident on the two specific points that we think matter.
• Governance needs to be understood in the round, key players involved are:
• Asset managers
• Investment consultants, scheme actuaries
• Trustees including professional trustees
• Corporate sponsors
• Over recent years there have been material steps up in the quality of industry governance on average, for example:
• Governance of schemes has been a significant focus of TPR for some time, including an imminent publication of a single code of practice
• The increase in the number and involvement of professional trustees over recent years
• There are a number of robust approaches to LDI governance that can be put in place by any size of scheme that in our experience functioned well during this period.

• For example, setting up “collateral waterfalls” consisting of liquid assets arranged to be easily accessible to the LDI fund manager. These could be funds run by the same manager or held structurally within the same investment wrapper. These funds can also be arranged such that the fund manager accesses them automatically in the case of a collateral need, allowing the scheme to satisfy collateral calls even at short notice.
• In our view eliminating the possibility of leverage within pension scheme risk management solutions would be capital inefficient, increase other risks in the pension system, and result in additional £100s of billions of extra pension costs for UK PLC (who sponsor the schemes). In turn, this would be at the cost to investment in their business and the economy, and reductions in dividends to shareholders.

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

• LDI needs to be robust in a world of higher gilt yield volatility.
• We think two main changes are needed to make LDI fit for purpose, and progress has already been made on both of them:
• More capital held against derivative positions to support higher levels of market volatility, lower leverage as a result, and larger cushions against rising interest rates to reduce the chance of schemes being required to reduce hedges.
• Operational arrangements to ensure that capital can be transferred more quickly and easily to the LDI manager, or additional assets placed with the LDI manager.
• We do see a case for regulating the use of leverage, but there are several potential pitfalls of over-regulation that could introduce unintended consequences that we believe should be avoided:
• For example, a leverage limit of, say, 2x while appealing is not practically helpful as it could encourage suboptimal behaviour by driving schemes to concentrate into the very longest dated gilts.
• Regulation structured in terms of yield buffer cushions could be seen as more technically robust but care needs to be given on how to allow for non-cash or non-gilt assets made-up as part of a broader waterfall of assets used to meet LDI collateral calls – treating these assets the same as cash, or ignoring these assets completely, could both be seen as inappropriate.

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

• We don’t think that this experience per se necessitates a change to the existing funding rules, we believe LDI can continue to operate safely with modest levels of leverage.
• Given the different experiences faced by pooled compared to segregated LDI accounts during the period (with the additional flexibility afforded by segregated arrangements generally being helpful) a closer look at the operations of the pooled fund universe would be appropriate in our view.
• Any considerations of future regulation need to be weighed against the already large volume of regulation that DB pension funds are required to comply with. Regulatory compliance consumes significant bandwidth and focus for most schemes.
• A regulatory requirement for an annual review of LDI with prescribed scenario tests of collateral requirements in a range of rising interest rates scenarios, influenced by (new) systemic risk considerations informed by Bank of England, FCA and TPR work, could be helpful. We think there is an important role for scenario-based risk modelling alongside the statistical models (which are typically calibrated using historical data).

November 2022