The turbulence in financial markets that followed the September 2022 mini-budget drew attention to the use of liability-driven investment (LDI) strategies by defined benefit (DB) pension funds. On 7 February 2023, Lord Hollick, chair of the House of Lords’ Industry and Regulators Committee (‘the Committee’), wrote to the government outlining a number of recommendations for improving regulation of LDI, which are summarised in this article.

Pension funds have used LDI strategies for around 20 years to protect themselves from adverse movements in interest rates and inflation and reduce the impact on their funding levels when interest rates fall.

An LDI strategy aims to match a pension scheme’s assets with its liabilities. Leveraged LDI is a way of increasing the amount of liability matching assets a fund has in place while maintaining investment in other asset classes.

Movements in the gilt markets following the mini-budget put significant strain on many DB pension funds using leveraged LDI as they were required to meet calls for substantial collateral in a short period of time to maintain their positions.

In the wake of the crisis, the Committee, in collaboration with the Economic Affairs Committee, wrote to the Bank of England, the Financial Conduct Authority and The Pensions Regulator as it felt further scrutiny of LDI was required. Several public and private sessions followed to take evidence on the use of LDI by DB pension funds.

Lord Hollick’s letter to the government gives recommendations for improving regulation and reducing the risk of similar disruption in the future.

The Committee’s key findings and recommendations are as follows:

  1. LDI strategies are a solution to an artificial problem

The fundamental issue is that leveraged LDI has been created as a solution to an artificial problem created by accounting standards but in the real world its application creates downside risks.

The government and the UK Endorsement Board should review the system of pensions accounting to see whether a less volatile, longer-term asset-led approach would be more appropriate for schemes that still have some time left to run.

  1. Use of leverage and derivatives

Underlying EU legislation and UK regulatory rules arguably do not permit the use of (a) borrowing for LDI strategies and (b) derivatives for hedging liabilities.

The government should review whether the use of leverage and derivatives by pension schemes should be more tightly controlled in the future. If schemes are to continue to use leveraged LDI, there should be far stricter limits and reporting on the amount of leverage allowed in LDI funds and greater liquidity buffers introduced for leveraged exposures.

  1. Trustees and regulation of investment consultants

The government should ensure that investment consultants are brought within the regulatory perimeter as a matter of urgency.

  1. Regulators, systemic risks and leverage

Regulators should ensure they have more information on the leverage present within pension scheme finances and that stress tests are conducted. The more bank-like strategies and instruments used by pension schemes are, the more bank-like its supervision should be. Further:

  1. The government should consider giving the Prudential Regulation Authority a role in overseeing pension schemes.
  2. The Pensions Regulator should be given a statutory duty or ministerial direction to consider the impacts of the pensions sector on the wider financial system.
  3. The Financial Policy Committee should continue to take the lead on systemic risks to financial stability and should be given the power to direct action by regulators in the pensions sector if they fail to take sufficient action to address risks.

Next steps

Lord Hollick’s letter was sent in advance of the House of Commons Work and Pensions Committee meeting in March, which will be attended by the Committee and at which government ministers will appear.

The Committee has requested a response to its letter by 7 March 2023.

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