In April 2023, The Pensions Regulator (TPR) published updated guidance to trustees of pension schemes on using Liability-Driven Investments (LDIs).
In this blog, I will summarise TPR’s guidance, explore what it means to you as a trustee, and showcase how Assure UK can help you meet your governance and monitoring goals as part of a pension scheme audit.
What is an LDI?
LDIs are an investment strategy that aims to match a pension scheme’s assets to its liabilities, thereby reducing the risk of a funding shortfall. It is a way of investing that gives multiple exposure to gilts. As you may remember, the Bank of England had to intervene in the gilt market in September and October 2022 to restore market functioning when sharp and rapid rises in gilt yields led to widespread selling of gilts by pension schemes’ LDI arrangements.
As a trustee, you are ultimately responsible for deciding how the assets in your pension scheme are invested. Your investments must be appropriate for your scheme and its members. You must put in place the right governance and controls, and understand the risks you carry in your investment strategy. At Assure UK, we can help ensure that your controls are operating effectively and efficiently so you can have confidence in how the assets in your scheme are invested.
Many defined benefit (DB) pension schemes use LDIs to better match their assets to their liabilities. An LDI can be leveraged or unleveraged. In leveraged LDIs, you use financial instruments to increase your allocation in certain assets (such as gilts, index-linked gilts, and fixed income derivatives), and these financial instruments require you to provide collateral to counterparties as security. The use of leveraged LDIs brings additional liquidity risks and requirements as these collateral demands can change over short periods when interest rates change.
The guidance released by TPR sets out specific issues to consider when investing in LDIs, including:
- where LDI fits within your investment strategy
- setting, operating and maintaining a collateral buffer
- testing for resilience
- making sure you have the right governance in place
- monitoring LDI
Investment Strategy & Collateral Resistance
As a trustee, you should review your investment strategy on a regular basis and when there have been significant changes to your scheme’s circumstances or market conditions. Your investment strategy should be outlined in your Statement of Investment Principles (SIP) and should be reviewed at least every three years. This is to ensure that you maintain a good standard of LDI resistance.
It is important that you consider the benefits and risks of investing in LDIs. The primary benefit of LDIs is that it can help to reduce the volatility of a pension scheme’s funding level. By investing in assets that closely match the scheme’s liabilities, the impact of market fluctuations on the funding level can be reduced. This can help to ensure that the scheme remains adequately funded and can meet its obligations to pensioners over the long term which is key for you to achieve as a Trustee.
On the other hand, LDIs require you to maintain a certain level of liquidity to meet collateral calls, which may impact your ability to invest in illiquid assets. If you are unable or unwilling to hold sufficient liquidity, you should consider your level of hedging with your advisers to ensure you have the right balance of funding, hedging and liquidity.
The LDI arrangements you invest in need to be resilient to short-term adverse changes in market conditions. To do this, cash, cash equivalents and assets are held as a ‘buffer’, which can be drawn on by the fund manager if additional collateral is called for as a result of changing market conditions. Only assets that can reliably be sourced or converted to eligible collateral in a timely manner should be held in the buffer.
As a trustee, you should make sure the arrangements you invest in operate an appropriate buffer, and that the right processes are in place for drawing on and replenishing the buffer.
There are two elements to consider in the buffer:
- Having sufficient liquidity to manage day-to-day volatility in the market (an operational buffer).
- Additional liquidity to provide resilience during severe market stress (a market stress buffer).
Schemes operate different investment governance models; Some trustees only delegate day-to-day investment decisions to an investment manager, while others delegate a range of investment powers to a fiduciary manager. Other governance models include in-house management and Outsourced Chief Investment Officers.
It is important that you understand how the investment governance model affects LDI implementation.
You should ensure that there are processes in place for monitoring the resilience of your LDI arrangements. At Assure UK, we’ve assisted a lot of trustees in ensuring that their processes are operating effectively and efficiently.