Written evidence from the Association of Consulting Actuaries (ACA)LDI0083

I write on behalf of the Association of Consulting Actuaries (“the ACA”), in response to your Committee’s supplementary call for evidence on defined benefit pension schemes (“DB schemes”) with liability driven investments (“LDI”).

Key additional comments

The ACA welcomes your supplementary call for evidence, in particular that it is focussed on the implications for the funding of DB schemes.

We responded separately last year to DWP’s consultation on the draft funding regulations and will be responding later this month to TPR’s current consultation on the draft Funding Code (that relates to the draft regulations).

We support the rationale for the new funding regulation and emerging funding code.  However our principal concern about the draft funding regulations is that they are potentially too narrow and so might unintentionally exacerbate systemic risks. 

In turn, our key concern about the proposed DB funding Code of Practice is that in several areas there are inconsistences between the wording in the regulations and the level of permissiveness envisaged by the Funding Code.  Collectively, these mean the new Code risks not facilitating as intended key “scheme specific” elements of the planned regime, that are potentially important to helping manage individual scheme and systemic risks.  We have commented further on these points below.

We have also commented on certain points raised in Lord Hollick’s 7 February 2023 letter to Andrew Griffiths MP and Laura Trott MBE MP.   This letter raised four key concerns in relation to LDI, which in summary are:

1. Whether leveraged LDI was created as a solution to an artificial problem created by accounting standards;
2. Whether underlying EU regulations were permissively transposed to allow leveraged LDI;
3. Whether there should be increased regulation of investment consultants; and
4. How systemic risk can be more effectively managed.

On the first of these points, our experience is that the main driver of LDI use is the ability to manage risks around the level of contributions needed to fund a DB scheme over time. 

There are potentially some exceptions to this (such as within the banking sector where accounting requirements can have a direct impact on capital requirements) but in our experience the sponsors accounting disclosures are rarely a key consideration.  Given this, we would suggest reframing this element of concern as relating to the DB funding regulations which the DWP is currently reviewing.  We have commented on this, and the other points raised below.

Risks in the draft DB funding regulations and TPR’s Code, which LDI has sharpened the focus on

Our previous letter to your Committee dated 15 November 2022 and our response to the DWP’s consultation on its draft DB funding regulations dated 13 October 2022 set out the ACA’s views.  Honing-in on the herding and systemic risks which the events of last Autumn brought to your Committee’s attention, we would highlight the following key points:

• Investment risk should be considered within the broader context of a DB scheme’s funding strategy and the ability of its sponsor to support the risks being taken.  Whilst the events of last Autumn may have led to some DB schemes incurring investment losses, our experience is that there have been very few instances where losses are beyond that DB scheme’s sponsor’s financial capacity to remedy.  Many other schemes will have also improved their funding levels on key long term funding measures (such as the cost of buying out liabilities with an insurer)

• It is difficult to overstate quite how unprecedented the rapid increases in gilt yields was in the period leading up to and immediately following the mini-Budget with yield movements in a many single days during September 2022 exceeding movements that would historically have taken several years.   

• Systemic risks have always existed in the DB scheme investments.  Historically for DB schemes they generally related to equity investments (stock market falls typically led to deficits, requiring additional contributions to restore funding levels).

• However, these systemic risks have gradually shifted towards investments in bonds, particularly gilts, as more DB schemes have closed to new entrants and future accrual and begun planning for “run off”.  In turn, this has shortened the time available to correct falls in funding (whether these arise from poor investment returns or other experience such as members living longer). This trend will continue as DB schemes mature.

• As DB schemes mature they also need to realise assets to pay pensions.  Planning to hold bonds to maturity helps to match these cashflow requirements and so makes bonds increasingly desirable over time rather than relying on more volatile assets, like equities. 

• This has led industry practice towards designing long-term funding targets based on the prevailing price or yields of bonds, and this has been increasingly formalised through regulatory guidance.  In turn, leveraged LDI became widely adopted as a mechanism for insulating funding levels, and resulting cash requirements, from movements in gilt yields.

• Many DB schemes aim to “buy-out”, by purchasing insurance policies for members.  PRA’s regulations also lead insurers to adopt bond-based investment strategies, with substantial additional capital buffers. This further encourages maturing DB schemes to target gilt and bond investment strategies as they mature, as a proxy for insurer buy-out pricing.

Drawing the above points together, there are key structural and regulatory aspects of the UK’s DB landscape which led DB schemes in the direction of using LDI.  Whilst the impact of leveraged LDI last Autumn was significant, it is also reassuring that it did not lead to the collapse of pension schemes, poor outcomes for DB members, or unaffordable contribution requirements for the vast majority DB scheme sponsors.

New draft DB funding regulations and draft code of practice.

Turning to the new proposed regime, we would offer the following additional points:

• Whilst we can make generalisations about the characteristics of DB schemes, in practice there is a large variety of circumstances among schemes and a wide range of independent views among market participants.  This, together with shortcomings of earlier standardised funding regimes (most notably the MFR), led to the Pensions Act 2004 which implemented the current scheme-specific funding regime.

• The current regime has enabled DB scheme funding to improve substantially, DB scheme investment risks to be reduced and better managed and the security of DB pensions to be significantly improved.  This has all been achieved in ways generally affordable to scheme sponsors by virtue of the regime’s flexibility (which enable them to set strategies appropriate to their circumstances). We believe it is important, both for individual schemes, and systemically, for these key features to be safeguarded in the new regime.

• For example, a key feature of the DB landscape is the existence of a small number of very large schemes with multiple billions of pounds of assets (including some of the most diverse situations, such as schemes open to new members, schemes backed with Crown guarantees and schemes with systemically material sponsors) as well as a large number of mid-sized and a very large number of small schemes.

• The largest schemes often enjoy significant governance budgets and a level of regulatory oversight, which gives them capability and desire to pursue investment strategies that are not as closely aligned to the systemic risks mid-sized and smaller DB schemes face.   We believe these dynamics will have historically helped to manage systemic risks and if regulation inadvertently forces these schemes to pursue the same strategies as others, it could exacerbate the herding and systemic risks seen last Autumn

• Given the above, we believe it is important that key flexibilities in the current scheme-specific regime are safeguarded.  However, we believe these flexibilities are currently insufficiently protected by the draft funding regulations, specifically:

• The “low dependency asset allocation” that schemes will need to adopt when they are “significantly mature” (and move towards as they mature) may unnecessarily restrict flexibility, investment efficiency and innovation.  

• We support schemes being able to invest in appropriate levels of growth assets, where this is justified by the strength of the employer covenant and/or contingent assets and where short to medium term liquidity requirements are properly managed. The legislation should be flexible enough to allow this, maintaining an important element of scheme specific funding.

• We are particularly concerned at requirements in draft regulation 5, which require scheme assets to be invested so that “the value of assets relative to the value of scheme’s liabilities is highly resilient to short-term adverse changes in market conditions” and “in such a way that the cash flow from the investments is broadly matched with the payment of pensions…”.  If viewed restrictively, this seems likely to exacerbate existing herding behaviours. Changing this and to an or in Regulation 5 may greatly reduce this risk.

• In addition to restricting the assets that can be held as schemes become more mature, the draft regulations would also prescribe the point at which schemes are considered to be “significantly mature” and the financial metric by which it will be regulated (duration).  This risks further removing flexibility for schemes to take a variety of actions, including pushing back their target date for de-risking, in response to market movements

• We generally have fewer concerns about TPR’s draft code of practice than we have about the draft regulations (although we will be responding separately to TPR’s current consultation in several technical areas).  Our primary concern is that the final regulations need to be drafted more widely for the “bespoke regulation” route in TPR’s code to be able to operate effectively in the scheme-specific way envisaged. 

• We also see little in the proposed regulatory framework that seeks to specifically manage systemic risks.  Building on this point, we perceive there is an inconsistency with wider government policy advocating pension scheme investment in patient capital and UK infrastructure, as the new funding regulations appear likely to encourage further investment in gilts. 

Further questions raised in relation to LDI

To consider other points raised in your call for evidence and Lord Hollick’s letter:

• The Bank of England’s FPC December 2022 recommendations: our experience is that market practice has already moved substantially following the mini-Budget, increasing collateral and reducing leverage in LDI funds.  It seems reasonable for the events of last Autumn to lead to stronger regulatory oversight of LDI and ACA supports this.  However, we are concerned that any mandated or knee-jerk regulatory requirements may lead to greater systemic instability risks, by exacerbating herding and creating pinch-points in financial markets.

• On the regulation of investment consultants advising DB schemes, the vast majority of investment consultants are already regulated, either by the Institute and Faculty of Actuaries or by the Financial Conduct Authority.  We would suggest reframing the focus of any review on the effectiveness of existing regulation, rather than addressing a “regulatory gap”.  At present, ongoing work is being carried out by Government to establish the Audit, Reporting and Governance Authority (“ARGA”), whose role will include overseeing the regulation of actuaries undertaking work deemed to be in the public interest. A concern the ACA has in relation to ARGA’s regulation of actuaries delivering investment advice is to ensure non-actuaries are held to equivalent advice standards.  To this end, the ACA supports common requirements of care and conduct across all market participants.

• On the legality of leveraged LDI arrangements and the Interpretation of EU regulations on derivatives into UK law, we are not lawyers, so will refrain from offering detailed commentary here.  However, we would note that our collective experience is that leverage in LDI has primarily been aimed to manage or reduce risks within the cost constraints of DB scheme funding and has been generally encouraged by the existing regulatory regime.

The ACA is eager to continue to assist the committee and regulators in developing appropriate and well thought-through updates to the UK regulatory landscape, including the emerging DB funding regime, so as to best protect DB scheme members and scheme sponsors for the decades to come.

This letter is intended to provide general information and guidance only. It does not constitute legal or business advice and should not be relied upon as such. Responding to or acting upon information or guidance in this ‘paper/document’ does not constitute or imply any client /advisor relationship between the Association of Consulting Actuaries and/or the Association of Consulting Actuaries Limited and any party, nor does the Association accept any liability to any person or organisation relating to the use of such information or guidance.

March 2023