Written evidence from The 100 Group Pensions Committee LDI0062

Inquiry on defined benefit schemes with liability-driven investments (LDI)

We are writing on behalf of the Pensions Committee of the 100 Group of Finance Directors with regard to the above-named Inquiry.

About the 100 Group

The 100 Group represents the finance directors of the FTSE 100, several large UK private companies and some UK operations of multinational groups. Our member companies represent around 90% of the market capitalisation of the FTSE 100, collectively employing 6% of the UK workforce, and pay, or generate, taxes equivalent to around 12% of total UK government receipts.

Our overall aim is to promote the competitiveness of the UK for UK businesses, particularly in the areas of tax, reporting, pensions, regulation, capital markets and corporate governance.

The 100 Group represents companies sponsoring defined benefit (DB) pension schemes with assets of approximately £590bn at the end of 2021 and membership of 3.5m (around a third of the overall DB universe).

Background

As you will be aware, some UK defined benefit pension schemes (DB Schemes) had liquidity issues caused by the calls for additional collateral from LDI managers following the ‘mini-budget’ on 23 September 2022 and the subsequent extraordinary rise in gilt yields (LDI Issues).

It is important to note that DB Schemes did not become insolvent and the majority have seen improved funding levels over the course of 2022 (and indeed are at historically high levels of overall funding coverage). Nevertheless, the liquidity issues did result in intervention from the Bank of England to stabilise the market. In addition, there is now an increase reliance from DB schemes on illiquid assets.

We absolutely recognise the need for lessons to be learned from such events (even given the unpredictability of the circumstances leading up to and precipitating the extreme changes in long dated gilt yields). For example;

• the general practice has already moved to have higher collateral buffers, thereby implicitly limiting levels of LDI leverage, and
• we anticipate the need to review governance arrangements to ensure that all schemes have sufficiently robust processes in place to understand the risks and the ability to take mitigating action swiftly in response to market movements.

We are however aware that the W&P Committee heard a wide range of views, including a number of very extreme views about the use of LDI strategies within DB Schemes.

We are therefore writing to stress the important role that leveraged LDI investment strategies have played in efficiently and appropriately managing key pension scheme risks, which, along with the cash contributions made by sponsors, has resulted in a steady improvement in the financial position of most DB Schemes. Moreover, we want to ensure that any regulatory action avoids discouraging hedging, which would lead to more risk and cost for schemes and their sponsoring employers.

The role of leveraged LDI strategies in the management of pension scheme risks

DB Schemes face interest rate risk and inflation risk. These risks, if not properly managed, can cause material volatility in DB Schemes’ funding levels as they can materially change the current actuarial value of a DB Scheme’s liabilities (and, as a consequence, the amount of assets required to be held to meet those liabilities).

As an example, a DB Scheme’s discount rate (which is central to the actuarial calculation of the present value of the scheme’s liabilities) is linked to long-term market interest rates. If long-term interest rates fall, the actuary will assume a lower rate of return on scheme assets. This would mean that it needs more money today to meet its liabilities in the future (i.e. the present value of the liabilities increases). The opposite is true for a rise in interest rates.

The impact is significant because of the long-term nature of pension scheme liabilities and the scale of the liabilities in question. For example, a reduction in the discount rate from 4% to 3% is like saying that the DB Scheme will earn 1% less from its investments each year for the life of the liability. If the liability is 20 years in the future, this is like an impact of around 20% on the present value of the liabilities. As the liabilities in the DB Schemes of our members are valued typically in the billions of pounds, the scale of the financial effect is easy to understand.

Most DB Schemes already hold a material (30%+) proportion of their assets in UK government bonds. In theory, it is possible for DB Schemes to achieve a higher hedge against interest rate and inflation risk by investing all or most of their assets in UK government bonds directly.

However, other than the fact that there are insufficient levels of inflation-linked gilts available to back the universe of funded DB Schemes, investing all (or the vast majority of) scheme assets in gilts would be highly inefficient and would have crystallised deficits at historic levels. In turn, this would have made UK businesses with DB Schemes highly inefficient and at a significant disadvantage relative to other businesses that do not have DB Scheme liabilities – and particularly against international comparators.

Instead, schemes can achieve a greater level of hedging, and a more precise liability match, by using leveraged LDI strategies. This involves the use of derivative instruments such as swaps and repurchase agreements.

These instruments enable a higher level of exposure to be obtained to the economic value of gilts. This is done through leverage supported by collateral. Interest rate and inflation swaps and gilt repurchase agreements are key components of a typical LDI strategy. At the same time, it frees up pension scheme capital to invest in assets with higher expected returns including credit assets, equities and infrastructure and property assets.

In effect, the assets in an LDI strategy hedge the DB Scheme’s interest rate and inflation risk as they are designed to match all (or a portion of) the interest rate and inflation risks in the pension liabilities. In doing so, the DB Scheme’s funding ratio is (largely) protected from volatility arising from changes in the liability valuation but can still invest an appropriate proportion in growth assets to help the DB Scheme’s funding level improve and become more secure over time.

LDI strategies have been used in this way predominately as a risk management tool (as opposed to risk seeking) to allow inflation and interest rate risk to be fully hedged, while progressively reducing broader investment risk (from what it has been) in an efficient and affordable pathway. This pathway ultimately takes schemes to full funding on a low dependency basis ideally by the time they are significantly mature. At this point the pension scheme would no longer be seen as dependent on the sponsor other than for extreme tail risks.

What would happen to DB Schemes if they could not invest in leveraged LDI strategies?

For most of the period during which LDI strategies have been used by DB Schemes, and particularly since the 2008 financial crisis, the UK has experienced a low interest rate environment with long-term real interest rates even being negative for prolonged periods of time. This has meant that actuarial discount rates have been lower, and the present value of liabilities higher, than they otherwise would have been.

During this time, leveraged LDI strategies have helped to insulate DB Schemes from sustained low long-term real interest rates, whilst allowing DB Schemes to invest and benefit from returns on growth assets.

This has been significant for the businesses that are responsible for funding DB Schemes because, with a more stable funding level, it has been easier to put in place contribution arrangements and investment strategies with the aim of closing funding deficits on an appropriate basis for the DB Scheme in question.

Without leveraged LDI in place, funding deficits would have been more volatile, and/or likely to have been significantly larger. The contribution obligations on sponsoring businesses would therefore have been much greater (and potentially more unpredictable). This, we believe, would have a material – and negative - impact on the UK economy as whole for many reasons.

Possible next steps?

We set out below our thoughts on next steps. In particular, our suggestions for how to respond to the LDI Issues would be for consideration to be given to:

1.      steps being taken to ensure the trustee boards of all DB Schemes have an adequate level of knowledge and understanding concerning the proper operation and oversight of an LDI strategy;

2.      investigating ways in which the acceptance of non-cash and gilt collateral can be accommodated, to avoid circumstances in which stress in the gilt market can lead to a self-perpetuating downward spiral of the kind identified by the Bank of England; and

3.      ensuring greater levels of regulatory oversight and supervision in respect of the level of leverage/collateral and liquidity held to support LDI strategies, particularly

by the LDI pooled funds in which smaller DB Schemes invest - considering that these tend to be domiciled in Ireland or Luxembourg. At the same time, ensuring a holistic, market sensitive, portfolio approach is taken when considering broader collateral requirements as well as considering access to other forms of liquidity.

We look forward to engaging with DWP and the Pensions Regulator on the detail of any future consultations focused on LDI.

January 2023