Pensions Regulator issues new LDI guidance
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Both sets of guidance are in response to last month's recommendations by the Bank of England's Financial Policy Committee, themselves a response to the gilts crisis of September 2022.
Andrew Patten looks at the key takeaways from the new guidance.
All pension trustees using leveraged LDI should be reviewing their investment approach in light of the new guidance.
Investment strategy & collateral resilience
The Pensions Regulator's guidance reminds trustees of the need to ensure they are satisfied with how leveraged LDI fits into their investment strategy and to keep this under regular review. It identifies, in particular, the need for trustees to understand collateral call risks and the availability of assets to meet calls. This was an issue in last year's gilts crisis, with some schemes lacking sufficient liquidity to meet calls and being forced sellers in a falling market.
The Regulator expects trustees to only invest in leveraged LDI arrangements which are resilient to market volatility. The guidance calls for trustees to have an appropriately sized operational buffer to deal with expected market movements and an additional market stress buffer. In setting the size of their operational buffer, trustees will need to take account of their wider investment strategy, how quickly assets can be realised and the costs of selling assets. In terms of the market stress buffer, while trustees will need to consider what is appropriate to their scheme's circumstances, the Regulator expects that, as a minimum, this should normally be able to deal with a market movement of least 250 basis points and enable collateral to be posted with five days. This minimum level of resilience should ensure that funds can absorb a severe but plausible stress (based on last September's shock) and still have a remaining level of headroom to operate during a period of recapitalisation, avoiding the need to sell assets. If they have not done so, trustees may want to engage with investment managers regarding what non-cash assets they may accept as collateral.
Governance & stress testing
The guidance emphasises the need for trustees to have robust and effective operational processes in place to ensure the resilience of their scheme to market shocks. Trustees should have systems in place to enable quick operational decision making with clear roles and responsibilities of those supporting the running of the scheme. As a result of the challenges of the Covid pandemic, many trustees should already find themselves well positioned in this respect, having put in place rapid reaction arrangements, with appropriately delegated powers. Processes should factor in investment managers' operations and what actions can be automated where there this is likely to be insufficient resource for dealing with manual instructions.
The Regulator is encouraging trustees to consider adopting a collateral management policy, detailing the processes for meeting collateral calls and factoring in how stressed market conditions may impact the ability to realise assets. Many schemes, for example, will already have a pre-agreed "waterfall" policy, giving investment managers the authority to realise assets, in a certain order, to meet collateral calls. Trustees should also consider engaging with sponsoring employers regarding whether a temporary employer liquidity facility would benefit the scheme (and indirectly, the sponsor), avoiding the need to realise scheme assets in a falling market.
The guidance highlights, as in many areas of scheme governance, the importance of contingency planning and trustees stress testing their systems and processes to ensure they work well. Trustees are encouraged to work with their investment consultants, LDI managers and other advisers to design and implement test scenarios and keep written records of their testing and recommended changes to risk management processes, in response to lessons learned.
The guidance also suggests trustees ask their LDI manager what steps they have taken to meet the good practice in LDI management set out by the FCA and, in relation to pooled funds, how they meet the guidance put out by the Irish and Luxemburg authorities.
As part of their governance arrangements, trustees should also consider how they monitor their LDI arrangements – how often this is done and by whom and the information and advice required. In most cases, it is likely to be appropriate for the scheme's investment consultants to undertake the monitoring and provide advice and recommendations to a trustee investment committee on a regular basis and on the occurrence of certain agreed trigger events.
FCA recommendations
The FCA's guidance and recommendations cover similar ground to the Pensions Regulator's guidance. While aimed at LDI managers, trustees may also find it useful reading.
The guidance highlights deficiencies which contributed to last year's problems, including poor risk management and a lack of stress testing and contingency planning. As many trustees and advisors experienced, other areas noted as in need of improvement include, client communications and servicing and wider operational processes.
In terms of stress testing and contingency planning, the FCA's guidance recommends that firms consider multiple and simultaneous scenarios. For example, in addition to a significant increase in gilt yields, other market impacts or events impacting operational processes, such as a cyber-attack or a failure of a third party supplier, should be considered.
The guidance also emphasises the need for firms to know their clients better. This will enable managers to identify whether a significant number of its clients are adopting similar strategies (strategy concentration), leading to wider systemic risks as a result of being likely to respond in the same way to market challenges. Here, the guidance notes the fact that collateral calls earlier in 2022 resulted in many pension schemes having reduced holdings of liquid assets to meet the collateral calls occasioned by the September gilts crisis and being forced sellers of the same asset classes, further driving down gilt prices.
The FCA is clear that it expects firms to review and improve their product operations, including recapitalisation processes and buffer triggers and to make necessary changes to their operations to enable clients to be able to deliver collateral. It also expects investment managers to engage with clients to understand their investment objectives, risk management and view on charges to establish that they are using the most appropriate products for achieving their intended outcomes – for example, whether a pooled fund, or segregated mandate solution is best. The FCA also expects managers to do more to establish their clients' operational and communication preferences.
Finally, the FCA also highlights how conflicts of interest can arise in relation to LDI products. These can be between clients in the same fund, between clients in different funds, between LDI and non-LDI clients and between the firm and one or other of these groups of clients. The FCA is expecting managers to consider how potential conflicts can arise, to reviewing their approach to conflicts and to make any necessary improvements to how these are identified and fully managed.
All pension trustees using leveraged LDI should be reviewing their investment approach in light of the new guidance.
Investment strategy & collateral resilience
The Pensions Regulator's guidance reminds trustees of the need to ensure they are satisfied with how leveraged LDI fits into their investment strategy and to keep this under regular review. It identifies, in particular, the need for trustees to understand collateral call risks and the availability of assets to meet calls. This was an issue in last year's gilts crisis, with some schemes lacking sufficient liquidity to meet calls and being forced sellers in a falling market.
The Regulator expects trustees to only invest in leveraged LDI arrangements which are resilient to market volatility. The guidance calls for trustees to have an appropriately sized operational buffer to deal with expected market movements and an additional market stress buffer. In setting the size of their operational buffer, trustees will need to take account of their wider investment strategy, how quickly assets can be realised and the costs of selling assets. In terms of the market stress buffer, while trustees will need to consider what is appropriate to their scheme's circumstances, the Regulator expects that, as a minimum, this should normally be able to deal with a market movement of least 250 basis points and enable collateral to be posted with five days. This minimum level of resilience should ensure that funds can absorb a severe but plausible stress (based on last September's shock) and still have a remaining level of headroom to operate during a period of recapitalisation, avoiding the need to sell assets. If they have not done so, trustees may want to engage with investment managers regarding what non-cash assets they may accept as collateral.
Governance & stress testing
The guidance emphasises the need for trustees to have robust and effective operational processes in place to ensure the resilience of their scheme to market shocks. Trustees should have systems in place to enable quick operational decision making with clear roles and responsibilities of those supporting the running of the scheme. As a result of the challenges of the Covid pandemic, many trustees should already find themselves well positioned in this respect, having put in place rapid reaction arrangements, with appropriately delegated powers. Processes should factor in investment managers' operations and what actions can be automated where there this is likely to be insufficient resource for dealing with manual instructions.
The Regulator is encouraging trustees to consider adopting a collateral management policy, detailing the processes for meeting collateral calls and factoring in how stressed market conditions may impact the ability to realise assets. Many schemes, for example, will already have a pre-agreed "waterfall" policy, giving investment managers the authority to realise assets, in a certain order, to meet collateral calls. Trustees should also consider engaging with sponsoring employers regarding whether a temporary employer liquidity facility would benefit the scheme (and indirectly, the sponsor), avoiding the need to realise scheme assets in a falling market.
The guidance highlights, as in many areas of scheme governance, the importance of contingency planning and trustees stress testing their systems and processes to ensure they work well. Trustees are encouraged to work with their investment consultants, LDI managers and other advisers to design and implement test scenarios and keep written records of their testing and recommended changes to risk management processes, in response to lessons learned.
The guidance also suggests trustees ask their LDI manager what steps they have taken to meet the good practice in LDI management set out by the FCA and, in relation to pooled funds, how they meet the guidance put out by the Irish and Luxemburg authorities.
As part of their governance arrangements, trustees should also consider how they monitor their LDI arrangements – how often this is done and by whom and the information and advice required. In most cases, it is likely to be appropriate for the scheme's investment consultants to undertake the monitoring and provide advice and recommendations to a trustee investment committee on a regular basis and on the occurrence of certain agreed trigger events.
FCA recommendations
The FCA's guidance and recommendations cover similar ground to the Pensions Regulator's guidance. While aimed at LDI managers, trustees may also find it useful reading.
The guidance highlights deficiencies which contributed to last year's problems, including poor risk management and a lack of stress testing and contingency planning. As many trustees and advisors experienced, other areas noted as in need of improvement include, client communications and servicing and wider operational processes.
In terms of stress testing and contingency planning, the FCA's guidance recommends that firms consider multiple and simultaneous scenarios. For example, in addition to a significant increase in gilt yields, other market impacts or events impacting operational processes, such as a cyber-attack or a failure of a third party supplier, should be considered.
The guidance also emphasises the need for firms to know their clients better. This will enable managers to identify whether a significant number of its clients are adopting similar strategies (strategy concentration), leading to wider systemic risks as a result of being likely to respond in the same way to market challenges. Here, the guidance notes the fact that collateral calls earlier in 2022 resulted in many pension schemes having reduced holdings of liquid assets to meet the collateral calls occasioned by the September gilts crisis and being forced sellers of the same asset classes, further driving down gilt prices.
The FCA is clear that it expects firms to review and improve their product operations, including recapitalisation processes and buffer triggers and to make necessary changes to their operations to enable clients to be able to deliver collateral. It also expects investment managers to engage with clients to understand their investment objectives, risk management and view on charges to establish that they are using the most appropriate products for achieving their intended outcomes – for example, whether a pooled fund, or segregated mandate solution is best. The FCA also expects managers to do more to establish their clients' operational and communication preferences.
Finally, the FCA also highlights how conflicts of interest can arise in relation to LDI products. These can be between clients in the same fund, between clients in different funds, between LDI and non-LDI clients and between the firm and one or other of these groups of clients. The FCA is expecting managers to consider how potential conflicts can arise, to reviewing their approach to conflicts and to make any necessary improvements to how these are identified and fully managed.
For more information, please contact Andrew Patten, David Gallagher, Michael Calvert and Jeremy Harris.