In September and October of 2022, volatility in gilt prices reached unprecedented levels, as yields spiked and leveraged Liability Driven Investment (“LDI”) values plummeted. In the wake of events (labelled the “LDI crisis” by various media outlets including the Financial Times), the National Competent Authorities (NCA) and The Pensions Regulator (tPR) issued regulatory guidance concerning the use of LDI. More recently, the Bank of England (BoE) published its recommendations.
These pieces of regulatory guidance are not complete and much remains to be decided on how specific resilience procedures are performed. However, there are actions pension schemes can take now to improve the resilience of their portfolios to market shocks, specifically when using LDI strategies to manage risks.
tPR and NCA guidance
The initial regulatory guidance from the NCA focused on LDI funds being able to withstand a 3% to 4% points rise in yields before the net value within the LDI funds is depleted. tPR then issued a linking statement reiterating this buffer and encouraging schemes to improve LDI resilience to yield movements by taking a number of actions, in their “ten-point check list”. These points can be summarised as:
- Defining and monitoring procedures for meeting collateral calls (including collateral types, allocations, and payment schedules).
- Reviewing wider governance arrangements and ensuring they are robust (including signing procedures and re-balancing schedules).
- Stress testing both the LDI portfolio and the non LDI portfolio to yield shocks in line with the buffer agreed by the NCA of 3-4% points.
tPR then suggested these arrangements were documented and reviewed on a regular basis. They also confirmed that further guidance would be given in their Annual Funding Statement in April 2023.
Latest guidance from BoE
In the Financial Policy Committee’s (FPC) recent statement on LDI they reiterated the need for funds to be able to withstand periods of market stress without initiating a feedback loop and recommended that tPR specify minimum levels of yield resilience. The BoE recommends resilience to a yield shock of 2.5% points as part of normal operations. LDI funds can then take appropriate actions, such as deleveraging, to re-instate their minimum target levels of leverage. The BoE also recommended that tPR have the remit to consider financial stability considerations when performing its duties as a regulatory body.
How will the new regulation impact pooled LDI Funds?
Schemes that use LDI have already experienced reductions in leverage as funds adjusted to the guidance from the NCA and tPR. In doing this, funds have improved their yield resilience to increases of 3% to 4% points, which is in line with the minimum levels specified by the BoE.
What can Schemes do today to improve resilience?
We expect tPR’s Annual Funding Statement in April will provide further guidance on how schemes should monitor and assess their resilience to yield shocks when determining their financial stability. However, schemes can take a number of appropriate actions now based on the initial guidance. This includes updating and assessing both signing and collateral procedures, in addition to developing procedures in order to stress test the Scheme’s assets to yield shocks.
Some examples of actions trustees should make are outlined below:
- Assess the suitability of collateral holdings. This includes their suitability from a liquidity perspective and their value response to yield shocks. One method of improving resilience is to implement a collateral waterfall to increase the available pool of assets from which collateral can be met. It also allows schemes to specify a structure on which assets they would prefer to sell in turn, considering liquidity, dealing frequency, expected dealing costs, and value correlations with LDI.
- Assess the Scheme’s collateral levels and monitor them on an ongoing basis. This entails reviewing the collateral assets to ensure there are sufficient, monitoring this on an ongoing basis, and “topping up” if required.
- Develop collateral timelines and specify collateral procedures. This ensures that the scheme is able to meet collateral calls within the required timelines.
- Review and update authorised signatory lists. This can ensure documents are able to be signed in a timely manner should a liquidity shock occur.
- Review suitability of LDI arrangements. Following the initial guidance around stress testing, schemes should consider how their portfolios would respond to yield shocks and if there is scope to improve the resilience of their portfolios by reducing leverage. In addition, Trustees may wish to consider ongoing monitoring arrangements, for example, of hedge ratios or resilience in stressed scenarios.
If you have any questions, or would like to receive advice on how your scheme can meet the current regulatory guidance, please get in touch with us/your investment contact and we would be happy to assist you.
Quantum Advisory
April 2023