Non-market risks in liability driven investment (LDI): Getting it right

Liability driven investment (LDI) arrangements are legally complex. While they are often tailored to suit the requirements of individual schemes, there are a number of common legal issues which are critical to understanding and managing a number of risks in liability driven investment arrangements.

The Pensions Regulator requires Trustees to put in place the right governance and controls, and understand the risk they carry in their investment strategy.

Segregated LDI mandates and Pooled LDI funds are legally very different creatures. In segregated mandates, the Trustee will become the legal party to all relevant arrangements such as the IMA and all derivatives and repo agreements. In pooled fund arrangements, the Trustee will only have a direct relationship with the relevant fund entity.  Non-market risks, such as counterparty credit risk, operational risk, compliance risk, legal risk are common to both – but in segregated mandates, it falls on the Trustee actively to design and shape the arrangement to manage these risks. By contrast, in pooled fund this becomes essentially, a due diligence exercise.

The critical challenge is to understand all of the underlying dynamics and how managing one risk or realising one commercial objective can result in unwanted trade-offs. For example, guarding against counterparty credit risk can raise the risk of a liquidity squeeze. More control for the Trustee can shift liability from the investment manager to other advisers.  

The liability of the Trustee and the ability to recover for losses will depend on how well these dynamics are understood and addressed.

The paper deals with:

• Legal Relationships and Set-up
• Counterparty Credit Risk in LDI Arrangements
• Collateral
• Liquidity Risk
• Compliance Risk - Derivatives Regulation
• Additional considerations for Pension Scheme Trustees
• Contractual terms and recourse
• IMAs
• Engagement terms with third party advisors
• Derivatives / Repos
• Legal Enforceability
• Recourse
• Pooled Funds

Download the full article: Non-market risks in liability driven investment.