The Industry and Regulators Committee has criticised defined benefit (DB) pension funds for using leveraged liability-driven investing (LDI) strategies and is calling for steps to strengthen regulation and lessen the possibility of future disruptions of a similar nature.
In its report on the LDI crisis, the House of Lords Committee expresses concern that regulators did not pay enough attention to the risks and hazards that borrowing to boost investment returns could pose to pension scheme finances and wider financial stability in the event of rising interest rates.
The report found that liability-driven investment strategies, especially those that employ leverage, were developed as a response to an artificial issue brought about by accounting standards, which force sponsoring companies to place a greater emphasis on short-term estimates of pension deficits than on long-term ones. By investing in bonds, pension plans tried to reduce the volatility of these projections, but because these investments produced poor yields and the funds were needed to cover deficits, they had to borrow to increase returns.
It also revealed that the relevant EU legislation, which appears to have been permissively transferred in the UK to let pension schemes to continue utilising such techniques, forbids the use of borrowing and derivatives for these objectives.
The report also indicated that some pension scheme trustees probably were not aware of the potential consequences of their LDI strategies and that it was difficult for them to make decisions at the same pace as the markets. This has made them reliant on the advice of investment consultants, whose recommendations to schemes are currently unregulated and might not be thorough enough to cover all aspects of the portfolio or operational needs.
In addition, it found that regulators in the industry appear to have taken a while to recognise the systemic risks brought on by the concentration of pension schemes’ ownership of assets like index-linked gilts and the growing use of more sophisticated, bank-like strategies and instruments by pension funds, despite calls for more information and a review of stress tests from the Financial Policy Committee.
The Committee calls for steps to strengthen regulation and lessen the possibility of future disruptions of a similar nature including a government and UK Endorsement Board review of whether the current system of accounting for pension scheme finances in company accounts is appropriate and whether to introduce a system that does not drive short-termism in pensions investment as well as a review of the relevant regulations and consider whether the use of repos and derivatives should be more tightly controlled and supervised in future.
It also suggested that 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.
Industry and Regulators Committee chair Lord Hollick says: “The evidence we heard overwhelmingly suggests that the use of LDI strategies caused the Bank of England intervention. If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction, rather than a downward spiral in government debt markets that threatened the UK’s financial stability and led to significant losses as pension fund assets had to be sold in order to meet LDI liquidity requirements.
“The impacts of accounting standards and the widespread adoption of leveraged LDI have transformed pension schemes from being long-term institutions into ones focused mainly on short-term volatility in prices and interest rates.
“We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the Government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes. This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again.”
LCP partner Jonathan Camfield says: “There is a strong case for further improvements to the regulation of pension scheme investment strategies, following the turmoil of last autumn. Individual pension schemes may well have made decisions that made sense in isolation but these had knock-on impacts for the financial system as a whole, and this is an area where closer regulatory oversight would have led to a less bumpy ride.
“However, the Bank of England already has a role to look at system-wide issues such as this, and, working in partnership with the Pensions Regulator could be tasked with making sure that the system as a whole is less vulnerable to shocks going forward. I am however sceptical that the underlying cause of these problems was the accounting rules which apply to pension schemes. Pensions schemes decide their investment strategy primarily on the basis of the law and regulations which come from the Government and the Pensions Regulator, and it was this framework which was the primary driver for the use of leveraged LDI in the first place”.