Written evidence from Dalriada Trustees Limited LDI0073

Evidence

The Pensions Regulator’s (TPR) consultation on its draft funding code of practice for defined benefit (DB) pension schemes, launched on 16 December 2022. The Committee asked TPR to postpone the consultation until it had reported, in light of concerns that had been raised that the proposals would result in increased herding in pension scheme investments. TPR did not agree but said that if the consultation raised fundamental concerns, it would consider whether further consultation was needed.

We agree that the behaviour of pension schemes as regards investments and hedging in particular are heavily influenced by the prevailing funding regime. From the latest consultation material from TPR, it is clear that gilt based funding measures are going to continue to be favoured. It is also quite clear that once a pension scheme has attained a level of funding that is deemed satisfactory in term of the ‘fast track’ principles that it will be deemed most prudent to set a relatively high level of hedging against that measure.

With the recent improvements in funding and with the likely continued increase through the more controlled new funding regime, it is reasonable to expect that, in the relatively near term (within the next 10 years), the majority of UK DB schemes will be fully funded on a ‘low risk’ basis and will have high levels of hedging. On the grounds that the schemes will be ‘fully’ funded, there should be much less need for leverage and we would expect many schemes to deploy no or minimal leverage. This (alongside increased guidance from TPR as well as changes to leverage levels within the various LDI providers) should significantly reduce the risk of a recurrence of the liquidity squeeze that drove the ‘gilt’ crisis. There are, however, a number of other areas that would concern us.

The size of the UK DB liabilities far exceeds the available amount of medium and longer dated gilt issuance and there is a strong argument that, if regulation pushes pension schemes to invest in specific assets regardless of the price of that asset, the market would become distorted. Many commentators would argue this is already the case but the situation is likely to be exacerbated as more schemes reach ‘full’ funding.  Solvency II potentially has similar effect on the UK life insurers in terms of herding asset buyers towards specific asset types.

Arguably the bidding up of gilt prices may be a good thing for the Public purse as it allows the Government to borrow at a cheaper level than they should otherwise be able to. It could though have negative impacts for both investment in the economy and for the prices of other assets.

Insurance buy-outs will to an extent offset this but, at the same time, create a twin track world where schemes not insuring are more or less obliged to hold gilts; whereas, if schemes do pass to insurers, the insurer then has the relative freedom to invest in a wider pool (global credit) but in a less conservative manner.

There is a strong argument that, if schemes are so well funded to be able to hold entirely risk free assets, the sponsor has paid in too much money. At an aggregate level, if sponsors have paid in too much, this money would otherwise likely have found itself into investment in economic activity and from this point of view there is an argument that the prudence of the regulation has an inhibiting impact on the UK economy.  However many sponsors are global entities, so money saved in the UK could be used elsewhere.

We do of course support the provision of security for members. The current structure of DB Schemes is not supportive of delivering this and at the same time supporting economic growth and sensible long term investment principles.  It is also worth bearing in mind that the duration of DB schemes is relatively short as compared to large infrastructure projects.  We can comment further on this if it is of interest to the committee.

The Bank of England’s Financial Policy Committee’s recommendations in December that TPR should take regulatory action, in coordination with the Financial Conduct Authority and overseas regulators, to ensure LDI funds remain resilient and, longer term, set out appropriate steady state minimum levels of resilience for LDI funds including in relation to operational and governance processes and risks associated with different fund structure and market concentration.

We are supportive of increased regulation of LDI funds and would expect such regulation alongside the recent TPR guidance to help alleviate some of the pressures that led to the 2022 gilt crisis. However, we believe the issues that arose were as much down to the quality of advice and decision making within the area of hedging and therefore, as previously suggested, we believe it is important that:

1.                  The quality (and in particular technical understanding) of Trustee boards is increased.  No Trustee Board should invest in any product unless they fully understand the purpose of the investment, the manner in which it works, the advantages and disadvantages, the specific characteristics of the product chosen, the quality of the manager, the detail of the advice, where the risks lie, and what proper ongoing governance of the investment looks like. Accordingly we would argue for regulation of trustees both across all of the decision areas.
2.                  The quality and accountability of the investment advisers is significantly increased. We believe all investment advice should be regulated by the FCA and not by professional bodies. We expect that of the many schemes that suffered losses through the gilt crisis, few will be able to achieve redress because of the provisions of the investment management agreements with LDI managers and the engagement terms with investment consultants will make seeking financial redress expensive and risky.

We would note that this regulation will lead to higher costs to UK DB pension schemes.

February 2023