Written evidence from Baroness Bowles of Berkhamsted, House of Lords (LDI0060)

Sir Stephen Timms MP,

Chair, Work and Pensions Committee

cc: Lord Hollick, Lord Bridges

10 December 2022

Dear Sir Stephen

I am aware of the Parliamentary inquiries concerning LDI and market turbulence and I am a member of the Industry and Regulators Committee. It has come to my attention that you are interested in the transposition of the IORPS directive and I thought it might be helpful to put down my knowledge from while I was chair of the Economic and Monetary Affairs Committee of the European Parliament and my observations on the transposition. Below is a brief account of how I encountered it, key transposition points and a transposition table. I have also sent a copy of this letter to the chairs of other Parliamentary Committees that have been inquiring into LDI, leveraged LDI and its systemic effects.

IORPS was completed before I became an MEP (2005) but from 2009, while ECON chair, I was asked to be a keynote speaker and panellist to discuss review of IORPS at Commission conferences and events. There were also calls for investigation within the ECON committee. Informal advice given to me from HMT at various times was to defend IORPS and prevent it from being revised to be more like Solvency 2. I was also told ‘it was a difficult transposition and we don’t want the Commission opening it up’. The difficulty I was given to understand was to make the words cover what was already practice in UK DB schemes. The ‘wriggling’ (my expression) was regarded as justified due to the systemic size of DB schemes in the UK, few other countries having DB schemes and thus the Directive being ‘mainly about us’.

Due to the tsunami of post financial crisis legislation other matters took priority and it is only in the context of LDI and market turmoil that I have engaged again on IORPS itself. Also, as in the UK, Pensions were not technically under financial services and were thus left out of the financial stability revisions, a situation that still pertains today.

The summary and transposition table below show the changes the UK made to the wording used in the Directive. These changes are pertinent to the use of borrowing, leverage, derivatives and

the nature of permitted risks. Prudence also requires interpretation in the context of the Directive as well as native UK provisions.

When interpreting legislation transposing an EU Directive, the ECJ held, in Marleasing, that member state courts must: “ in applying national law …..do so, as far as possible, in the light of the wording and the purpose of the directive in order to achieve the result pursued by the latter”[1]. In respect of retained EU law (which includes the Occupational Pension Schemes (Investment) Regulations 2005)[2] this approach is specifically confirmed as continuing in the European Union (Withdrawal) Act 2018, as amended, section 6(3):

“Any question as to the validity, meaning or effect of any retained EU law is to be decided, so far as that law is unmodified on or after IP completion date and so far as they are relevant to it—

(a) in accordance with any retained case law and any retained general principles of EU law, and

(b) having regard (among other things) to the limits, immediately before IP completion date, of EU competences.”

with retained case law defined in section 6(7) to include the Marleasing case.

In summary:

On borrowing: The directive’s general prohibition on all borrowing has been narrowed in UK transposition to ‘borrowing money’. The effect is to permit borrowing, or leverage, through other mechanisms. Repo is a form of economic borrowing though it is claimed by others (eg L&G in evidence to Industry and Regulators Committee) not to be borrowing on the basis that it is a sale and a repurchase. Leverage is defined in dictionaries as borrowing to invest. The Pensions Regulator claims in a letter to the I&R committee that repo is a derivative.

On derivatives: The directive allows Investment in derivative instruments for reduction of investment risks or to facilitate efficient portfolio management. The UK has left out investment – relevant because LDI derivative and borrowing operations are used for liability matching not reduction of investment risk. UK also added Including the reduction of cost or the generation of additional capital or income with an acceptable level of risk as a part of ‘portfolio management’. The added words imply allowance of leverage (borrowing), with the narrowing of the borrowing definition only to money playing an enabling part and the Directive’s condition to reduce investment risk has been swapped to allowing increased ‘acceptable levels’ of risk.

As a further bit of smoke and mirrors the term ‘de-risking’ has been employed by industry and the Pensions Regulator for leveraged LDI to suggest it fits within the risk reduction requirement whereas it really means ‘bridging the funding gap using speculative methods’.

Other points: There is an overarching principle of ‘prudent person’ investment. Current practice might also show breaches in concentration risk in repo/bank counterparties and prohibited overlap/exposure in derivative operations.

Documents on the UK transposition. The above analysis is confirmed in the explanatory notes of the 2005 regulations and more particularly in the now archived consultation response (copy obtained via House of Lords Library forwarded with this letter). The consultation response clearly elaborates that the changes were indeed made to allow non-money borrowing, leverage through derivatives and investment in collective investments and insurance products with those characteristics. A full reading of the consultation response is suggested to the Committee especially pages 4 to 7. Paragraphs 7, 8, 9, and 10 relate to the borrowing and derivatives provisions and paragraph 11 to narrowing the meaning of ‘acting as a guarantor’ which might also have bearing on some borrowing and collateral obligations.

In Paragraph 2 it is made clear that the original regulations consulted upon were copied out from IORPS “concerns were expressed that the draft regulations’ copy-out approach to transposition of the Directive might lead trustees to adopt excessively cautious investment strategies”.

Then in Paragraph 9 it explains “One respondent was concerned to have received legal advice that the regulations would prohibit certain existing investment strategies”. The Government response was to draft around that to attempt to make them legal.

Paragraph 9 goes on to 9 “The terms “derivative instruments” and “efficient portfolio management” will be defined in regulations: “derivative instruments” in terms of the arrangements listed in MiFID2 ; and “efficient portfolio management” to include an intention to reduce risk and costs or generate additional capital or income with an acceptable level of risk (it remains for the trustees or delegated fund manager (as appropriate) to determine the level of “acceptable” risk based on the particular circumstances of their scheme).”

Paragraph 10 explains “The interaction between regulation 5, which restricts borrowing and prohibits trustees acting as guarantor also caused concern, respondents wanting reassurance that the regulation would not affect activities such as gilt repurchase agreements, non-financial borrowing, swaps, derivative instrument and borrowings by scheme subsidiaries, nor the use of borrowing or derivatives in indirect investment vehicles such as pooled funds, hedge funds and property unit trusts”

And the Government response is “Section 36A of the Pensions Act 1995 allows regulations to impose restrictions on trustees’ or fund managers’ ability to borrow money. The restriction in regulation 5 is thus limited to cash borrowing. It is not the Government’s intention to restrict the activities in the example given above. We believe that defining the term “derivatives” will help to clarify the position legislatively”.

It is worth noting that the ‘borrowing money’ provision in the Pensions Act 1995 was not a pre-existing one, it was inserted by the Pensions Act 2004, as part of the transposition of IORPS 2003.

Paragraph 11 continues with another restriction of meaning to enlarge borrowing capabilities “We understand that Article 18(2), by prohibiting the institution from acting as guarantor for a third party would prevent trustees, or as the case may be the delegated fund manager, from guaranteeing another party’s borrowing. The regulation will be amended to clarify that the trustees, or delegated fund manager may not guarantee the liabilities of another person.”

Thus it is clearly laid out that redrafting away from the wording of the Directive was deliberately done to bring inside the transposition various investment strategies that the Directive excluded and the term ‘reduction in investment risk’ effectively swapped to increased (acceptable) investment risk.

Reference to the specific consultation response paragraphs is also incorporated into the comments in the table below, the key comments corresponding to the points above are in red.

I am happy to provide further elaboration if required. In my view the changes to restrictions and reversal of meaning depart from the result required by the Directive.

Duty of UK courts when interpreting transposing legislation: Given the UK courts’ duty, there is risk that these adjustments to the wording of the directive are of no effect and would be ignored.

Transposition of IORPS Directive 2003 (investment criteria)

EU IORPS Directive 2003 Article 18 [3] (now consolidated and updated in the 2016 IORP II Directive- but with no substantive changes for the purpose of this Table)

UK transposition

Pensions Act 2004 s246

The Occupational Pension Schemes (Investment) Regulations 2005 Reg 4 & 5

Comment

18.1. Member States shall require institutions located in their territories to invest in accordance with the ‘prudent person’ rule and in particular in accordance with the following rules: (a) the assets shall be invested in the best interests of members and beneficiaries. In the case of a potential conflict of interest, the institution, or the entity which manages its portfolio, shall ensure that the investment is made in the sole interest of members and beneficiaries;

The prudent person rule is a longstanding part of UK trust law. The Pensions Act 1995, s 33 prevents pension schemes contracting out of the prudent rule. So no additional transposition was necessary.

(a) the assets shall be invested in the best interests of members and beneficiaries.

In the case of a potential conflict of interest, the institution, or the entity which manages its portfolio, shall ensure that the investment is made in the sole interest of members and beneficiaries;

4.—(1) The trustees of a trust scheme must exercise their powers of investment, and any fund manager to whom any discretion has been delegated under section 34 of the 1995 Act(9) (power of investment and delegation) must exercise the discretion, in accordance with the following provisions of this regulation.

(2) The assets must be invested— (a) in the best interests of members and beneficiaries; and (9) Section 34 was amended by section 5 of the Trustee Delegation Act 1999 (c. 15), by paragraph 49 of Schedule 12 to the 2004 Act and by S.I. 2001/3649. 4 Document Generated: 2022-10-04 Status: This is the original version (as it was originally made).

(b) in the case of a potential conflict of interest, in the sole interest of members and beneficiaries.

Note the discussion of specialist mandates in para 6 of the consultation response. Managers with specialist mandates not covered by any overall view of prudence.

(b) the assets shall be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole. Assets held to cover the technical provisions shall also be invested in a manner appropriate to the nature and duration of the expected future retirement benefits;

(3) The powers of investment, or the discretion, must be exercised in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole

(4) Assets held to cover the scheme’s technical provisions must also be invested in a manner appropriate to the nature and duration of the expected future retirement benefits payable under the scheme.

These are elements of the prudent person principle. Prudent person also embedded in trust and common law.

(c) the assets shall be predominantly invested on regulated markets. Investment in assets which are not admitted to trading on a regulated financial market must in any event be kept to prudent levels;

(5) The assets of the scheme must consist predominantly of investments admitted to trading on regulated markets.

(6) Investment in assets which are not admitted to trading on such markets must in any event be kept to a prudent level.

(9) For the purposes of paragraph (5)— (a) an investment in a collective investment scheme shall be treated as an investment on a regulated market to the extent that the investments held by that scheme are themselves so invested; and (b) a qualifying insurance policy shall be treated as an investment on a regulated market.

(10) To the extent that the assets of a scheme consist of qualifying insurance policies, those policies shall be treated as satisfying the requirement for proper diversification when considering the diversification of assets as a whole in accordance with paragraph (7).

But see addition below

(9) Added by UK

These provisions discussed in paragraphs 7 and 8 of consultation response. Comments extremely permissive but avoids definition: ‘’The inclusion of the terms ‘predominantly’ and ‘prudent levels’ indicate that were all investments held outside ‘regulated markets’ trustees would risk being held in breach”

(10) Added. Explanation that insurance well regulated.

Has this led to introduction of more risky strategies allowed in the more highly regulated and capitalised sector (and prior to Solvency 2) to be introduced into Pension Schemes?

Consultation response has not distinguished between strategies in insurance and those in pension schemes

(d) investment in derivative instruments shall be possible insofar as they contribute to a reduction of investment risks or facilitate efficient portfolio management. They must be valued on a prudent basis, taking into account the underlying asset, and included in the valuation of the institution's assets. The institution shall also avoid excessive risk exposure to a single counterparty and to other derivative operations;

(8) Investment in derivative instruments may be made only in so far as they— (a) contribute to a reduction of risks; or (b) facilitate efficient portfolio management (including the reduction of cost or the generation of additional capital or income with an acceptable level of risk), and any such investment must be made and managed so as to avoid excessive risk exposure to a single counterparty and to other derivative operations.

Investment left out of the essential requirement of ‘reduction of investment risk’. In LDI derivatives are used for matching liability risk, hedging valuations.

This omission also works in concert with the following addition to swap to allowing rather than reducing investment risk.

Both parts differ from intended result of Directive

‘Including the reduction of cost or the generation of additional capital or income with an acceptable level of risk’ - all added by UK to imply this comes under portfolio management (rather than portfolio strategy). Explained in paragraphs 9 and 10 of consultation response. Leverage via derivatives ‘allowed’ due to borrowing change in regulation 5 that is also not in line with the directive.

Consultation response indicated these changes made to get around Directive prohibition. “One respondent was concerned to have received legal advice that the regulations would prohibit certain existing investment strategies”.

Note that the provision on excessive risk exposure could apply to derivative counterparties (banks) and if as the Pensions Regulator has told the Industry and Regulators Committee they consider repo as a derivative, then there should not be exposure to other derivatives, eg related interest rate swaps.

(e) the assets shall be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings and accumulations of risk in the portfolio as a whole. Investments in assets issued by the same issuer or by issuers belonging to the same group shall not expose the institution to excessive risk concentration;

(7) The assets of the scheme must be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings and so as to avoid accumulations of risk in the portfolio as a whole. Investments in assets issued by the same issuer or by issuers belonging to the same group must not expose the scheme to excessive risk concentration.

There has been high reliance on gilt repo – at times covering all liabilities exposing the pension fund to 3 substantive risks:

collateral risk: insufficient assets of the right type to post collateral when needed
interest rate mismatch risk: borrowing short term (no more than 1 year) using repos and paying short term interest rates and using the amounts borrowed to buy fixed interest gilts with a maturity of greater than 20 years to speculate on the interest rate differential.
Roll (or duration mismatch) risk: that the counterparty may not be willing or able to roll over the repo every year for 20 plus years. If the repo market ceased to function at a time of extreme stress, then, if the pension fund cannot buy back, out of other resources, the gilts due for repurchase, then they would be sold and collateral posted would only be returned to the extent of any surplus.

(f) investment in the sponsoring undertaking shall be no more than 5 % of the portfolio as a whole and, when the sponsoring undertaking belongs to a group, investment in the undertakings belonging to the same group as the sponsoring undertaking shall not be more than 10 % of the portfolio. When the institution is sponsored by a number of undertakings, investment in these sponsoring undertakings shall be made prudently, taking into account the need for proper diversification.

Member States may decide not to apply the requirements referred to in points (e) and (f) to investment in government bonds

The UK did not exercise this option in respect of (e ) but did so in respect of (f) For (f) see Pensions Act 1995, ss 40(2) and (2A), and the Financial Services (Regulated Activities) Order 2001, Article 77 read with Article 78 which carves out gilts (and which is why the Bank of England Pension Fund can invest substantially in gilts: https://www.bankofengland.co.uk/-/media/boe/files/about/human-resources/pensionreport.pdf )

18.2. The home Member State shall prohibit the institution from borrowing or acting as a guarantor on behalf of third parties. However, Member States may authorise institutions to carry out some borrowing only for liquidity purposes and on a temporary basis.

Pensions Act 2002 s246 Borrowing by trustees

After section 36 of the Pensions Act 1995 insert— “36A Restriction on borrowing by trustees Regulations may prohibit the trustees of a trust scheme, or the fund manager to whom any discretion has been delegated under section 34, from borrowing money or acting as a guarantor, except in prescribed cases.”

The Occupational Pensions Schemes( Investment) Regulations 2005

Borrowing and guarantees by trustees 5.—(1) Except as provided in paragraph (2), the trustees of a trust scheme, and a fund manager to whom any discretion has been delegated under section 34 of the 1995 Act, must not borrow money or act as a guarantor in respect of the obligations of another person where the borrowing is liable to be repaid, or liability under a guarantee is liable to be satisfied, out of the assets of the scheme.

(2) Paragraph (1) does not preclude borrowing made only for the purpose of providing liquidity for the scheme and on a temporary basis.

The Directive’s general prohibition on borrowing has been narrowed in UK transposition to ‘borrowing money’ which was inserted by Pensions Act 2004 into the earlier Pensions Act 1995.

The effect of this is to suggest allowance of borrowing or leverage through non-cash mechanisms is possible. This is explicit in the consultation response paragraph 10 and it also interacts to ensure allowance of leverage via derivatives.

Differs from intended result of the directive.

3. Member States shall not require institutions located in their territory to invest in particular categories of assets

It is questionable whether the Pensions Regulator does this through its funding regulations and practice

Yours sincerely

Sharon

Baroness Bowles of Berkhamsted