Written evidence from Insight Investment LDI0076

Executive summary

Insight Investment is one of the UK’s largest investment managers, managing £654bn in assets for pension schemes, insurers, sovereign wealth funds and financial institutions[1]. The majority of Insight’s assets under management are in risk management solutions (primarily liability-driven investment, or LDI) and fixed income.

Insight Investment has actively engaged with policymakers in matters relating to LDI for over a decade and we are keen to engage with policymakers on the market turmoil in September and October 2022, its impact on pension schemes, and lessons learned from it. Insight provided written evidence to the first inquiry on the same topic in November 2022[2], and Abdallah Nauphal, CEO of Insight Investment, provided oral evidence on 7 December 2022[3].

Given the improved funding status of many pension schemes and material reductions in LDI leverage following the market turmoil, pension schemes’ resilience has improved. As pension schemes continue to move towards fully funded status, their leverage and exposures to illiquid assets are expected to decline, meaning similar shocks will be even less likely in future. This should be considered by policymakers as they formulate the regulatory framework.

We are grateful for the Work and Pensions Committee for its focus on these issues and we are pleased to share our views on the second call for evidence on the same topic[4]. Key themes we would like to highlight include:

•        We support The Pensions Regulator (TPR) DB funding code proposals, which aim to support pension schemes’ long-term planning as they seek to fulfil their commitments.

•        We are supportive of the Bank of England’s Financial Policy Committee’s recommendations for regulatory action to ensure LDI funds remain resilient and set out appropriate steady-state minimum levels of resilience for LDI funds. However, in setting the steady-state minimum level of resilience, a careful balance must be struck between resilience, efficiency and risk management; and it is important that pension schemes are permitted sufficient time to top up buffers if minimum levels are breached. Inappropriate parameters, such as buffers that are set too high, could lead to negative consequences, including pension schemes being forced to cut liability hedges, endangering their funding status and ultimately leading to a greater burden on corporate sponsors.

•        When setting minimum standards, we ask that regulators consider the different structures used to implement LDI strategies and corresponding governance processes, to ensure any recommendations are suitable and avoid unintended consequences. Specifically, pension schemes typically access LDI strategies using one of three structures: multi-client pooled funds, funds-of-one and/or segregated portfolios. Legal and practical differences between them mean a one-size-fits-all approach may not be appropriate.

In a separate direct communication, the Committee requested details of the management information we provide to pension scheme trustees to help the Committee understand the information trustees will have to help them fulfil their duties in maintaining LDI resilience. We provide these details in an Appendix.

Insight Investment, March 2023

Call for evidence

The Committee is interested in any further views to inform its session with the Minister for Pensions and the Economic Secretary to the Treasury in March. It would also welcome comments on two specific developments:

•        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.

•        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.

Q1. Our views on the second TPR consultation on the draft funding code

We support the DB funding code proposals, which aim to support pension schemes’ long-term planning as they seek to fulfil their commitments. The code recognises the value of liability-hedging strategies to manage risks that could affect whether schemes can achieve their long-term objectives. LDI strategies, at their core, are about managing pension schemes’ portfolios with the objective of maximising the certainty of fulfilling their liabilities.

We support this goal and the overall approach the proposed code takes. As explained in our response to the Work and Pensions Committee’s first consultation on LDI, we believe LDI is fit for purpose and has a central role to play in helping pension schemes manage their asset and liability risks. The draft code recognises the importance of an LDI approach.

Furthermore, TPR has stated in the draft funding code that any LDI strategies are supported by adequate liquid holdings and prudent collateral buffers. We support the need for trustees to reassess their collateral sufficiency to ensure they remain prudent in light of events of September/October 2022. In our response to question 2 below, we offer further views on approach to collateral buffers and related regulatory considerations.

We will respond to the consultation in due course, offering some detailed comments on specific aspects of the draft code, but we would reiterate here that we support the draft code, its aims, and its overall approach.

Q2. Our views on the Bank of England's Financial Policy Committee's recommendations

Minimum levels of resilience

We are supportive of the Bank of England’s Financial Policy Committee’s recommendations in December[5] that TPR should take regulatory action, in coordination with the Financial Conduct Authority (FCA) and overseas regulators, to ensure LDI funds remain resilient and, longer term, set out appropriate steady-state minimum levels of resilience for LDI funds. We believe a carefully considered framework around minimum levels of leverage could help to increase financial stability.

We request that policymakers take into consideration the following:

• Any minimum levels of resilience for LDI should be in the form of a minimum yield buffer rather than a maximum level of leverage. A minimum yield buffer is a more reliable parameter to consider; two LDI funds with the same collateral sufficiency in terms of their yield buffer can have two different measures of leverage depending on the maturity profile of the LDI funds. The requirement should therefore be for LDI strategies to have sufficient eligible collateral, including money market funds, to meet this minimum yield buffer. 
• In setting the steady-state minimum level of resilience, a careful balance must be struck between resilience, efficiency and risk management. Setting minimum yield buffers too high could lead to pension schemes being forced to cut liability hedges or sell their return-seeking portfolio. This could have negative consequences: increased risk to pension schemes (due to the lower hedging of liability risks and/or fewer assets generating returns); and increased forced-selling risk, which in illiquid market conditions could lead to a repeat of the events in September and October 2022. Ultimately, these would likely necessitate higher sponsor contributions and an increased burden on the sponsoring company, thereby potentially negatively impacting the UK economy overall.
• We encourage the Bank of England, TPR, FCA, and national regulators of LDI funds, to work in close co-ordination with each other, allowing for representation of the sectors they regulate, when setting the appropriate level of minimum resilience. In determining these minimum standards, policymakers may wish to consider conducting an analysis of the potential implications, taking into consideration the liquidity profile and journey to fully funded status of pension schemes, financial stability risks, market liquidity of the index-linked gilts and other relevant factors.
• Alongside a minimum yield buffer, we believe it is also advisable for regulators to have visibility of assets held by pension schemes beyond the eligible collateral. Due to the fragility and concentration of the gilt markets, it is helpful if pension schemes are not in a situation where they are forced to cut hedges or sell gilts in an illiquid market again. In order to avoid this, we believe careful management and rebalancing of pension schemes’ other assets, ahead of breaching any minimum yield buffer, is important to preserve overall financial stability. We believe full transparency of pension schemes’ total assets for to regulators could help to assist this outcome.
• Any regulatory minimum standards should factor in the high market concentration of gilts, particularly index-linked gilts, by UK defined benefit pension schemes, and therefore the potential for the index-linked gilt market to become dislocated if pension schemes are required to forced sell their holdings in an unmanaged way. We would note that in the long run, this issue will become less prominent, because most pension schemes intend over time to fully fund their gilt holdings as their funding status improves.
• As such, pension schemes should not be forced to top up within an overly prescriptive timeframe if market conditions lead to minimum levels of resilience being breached. Instead, the regulatory framework should allow some flexibility and discretion so that the timelines for collateral top-ups reflect the market conditions at the time. This is to ensure that pension schemes are not forced to sell index-linked gilts into stressed markets with poor liquidity, where additional selling could lead to and/or exacerbate market dysfunction creating unintended consequences for both pension schemes and overall financial stability.
• Furthermore, we believe a transition period may be required for those pension schemes executing LDI strategies via segregated mandates that require a longer timeframe to restructure and rebalance the liquidity profile of their assets. Specifically, we believe that pension schemes using segregated mandates should be provided with temporary flexibility allowing them to remain below the regulatory minimum level of resilience as long as they explain the reasoning for doing so to the relevant regulator and set out satisfactory transition plans for rectifying the situation. Bearing in mind that bank counterparties to these mandates will typically have recourse to the full assets of the pension scheme – not just those that are allocated to the LDI strategy – we believe it is prudent to take this approach over forcing those pension schemes to sell their index-linked gilt holdings and cut their hedge.
• We support increased transparency to regulators and request the aforementioned regulators co-ordinate together in setting mutually agreed standards and establish methods of data sharing so that any risk of duplicative reporting or reporting of different parameters by the industry for the same portfolio are avoided. Further, we believe the periodic reporting should be proportionate and should include information on collateral resilience, distance to collateral calls, and a breakdown of pension schemes’ assets.

Other risk considerations

• We wish to highlight to policymakers a crisis that could arise in the future if UK inflation expectations were to fall significantly, thereby leading to a widescale selling of index-linked gilts for which there may be insufficient liquidity. A fall in inflation expectations may reduce pension schemes’ desire to hold index-linked gilts. This is because many pension payments linked to inflation are floored at 0% inflation, while index-linked gilts are exposed to deflation, meaning that fewer index-linked gilts are required to hedge pension scheme liabilities as inflation expectations fall. While sales of index-linked gilts in response to this may be slower than in September 2022 as pension schemes rebalance their portfolios at different times, there is the potential for a similar negative feedback loop.
• We request that policymakers co-ordinate with the Debt Management Office to manage risks associated with a fall in inflation expectations described above. We believe this issue could be addressed over time via the issuance of government bonds with different inflation linkages, such as with an inflation floor at 0% per annum; this would remove the need for pension schemes to sell index-linked gilt holdings as inflation falls, as the inflation sensitivity of the assets would be more closely aligned with pensions schemes’ liabilities.
• We encourage policymakers to ensure that banking regulation is proportionate and does not unduly restrict banks’ desire to receive collateral in different formats. As explained in our response to the Work and Pensions Committee’s first consultation on LDI[6], we believe there is scope for regulation to be improved to support non-cash collateral as eligible for posting as margin in both repo and derivative transactions.
• Finally, we wish to highlight that even with a robust risk management and regulatory framework setting out minimum levels of resilience, there is still a fundamental need for gilt markets to remain functional. The foundational role of the Bank of England and policymakers in ensuring market functionality cannot be ruled out by such measures.

Governance processes and risk management in different LDI structures

When setting minimum standards, we ask that regulators consider the different structures used to implement LDI strategies and corresponding governance processes. Specifically, pension schemes typically access LDI strategies via one of three structures: multi-client pooled funds, funds-of-one and/or segregated portfolios. Legal and practical differences between them mean a one-size-fits-all approach may not be appropriate.

Some important differences we would like to draw out include:

• Banks, as counterparties to pooled fund vehicles, have limited recourse to the assets of pension scheme investors, meaning it is broadly for pension schemes to either provide sufficient collateral within the framework set out by a pooled fund, or risk losing their hedge. However, for segregated mandates, bank counterparties typically have recourse to the full assets of the pension scheme. As such, the consequences (for bank counterparties) arising from a potential default situation are materially different.
• LDI managers are more able to engage with each individual client of pooled funds-of-one and segregated portfolios to better understand and reflect their specific circumstances. On the other hand, multi-client pooled funds tend to operate on a more rules-based framework.

Appendix: Client communication

In a separate direct communication, the Committee requested details of the management information we provide to pension scheme trustees to help the Committee understand the information trustees will have to help them fulfil their duties in maintaining LDI resilience.

Q1. How often you are communicating to clients, whether you are systematically communicating to all clients, and at what lag to the actual data.

Q2. Whether the data you are communicating includes:

•        The total level of collateral resiliency (split between holdings within the LDI fund and additional holdings with the manager)

•        The distance in terms of basis points to the next collateral call and how large this is likely to be

•        Any parameters / thresholds they are using for a red-amber-green system to guide clients

We believe we provide the appropriate information to allow our clients to plan and act effectively to maintain resilience.

We provide regular client communications, on a monthly or quarterly basis for all our LDI clients, including pooled fund and segregated clients; some clients and consultants receive more frequent information. The reports are provided within 1 and 25 business days following the relevant period end. In addition to this, when collateral adequacy requires discussion or actions to be taken, we engage with our clients and their advisers to take the appropriate steps.

For pooled fund clients, we provide a range of market stress tests which demonstrate the impact on collateral calls from potential market movements, and we highlight the distance to the next capital call and the size of the call. This is based on our red-amber-green framework, the parameters of which we make available on our website and are distributed to clients or consultants, as per each client’s preference. For segregated clients, we provide a range of market stress tests which demonstrate the impact on the portfolio’s net asset value to provide a view of collateral resilience and information in relation to potential collateral calls and the size of the call.

During 2022, we reacted to rising yields by making more frequent reporting available, and responded to high volumes of ad-hoc requests from clients, enabling them to rebalance their allocations with confidence. For example, for some clients, we provided daily reporting to them and their advisers. These daily updates included the prevailing collateral position and forward-looking scenario analysis, showing positions at the prior market close. Frequently, we also provided same-day analysis of the impact of possible changes clients were considering.

We continue to review the information we provide to offer the best service we can to our clients and their advisers.

March 2023