LDI – WHAT NEXT?
12th December, 2022
In a previous blog written by Paul Brine, we considered the aftermath of the ‘mini-Budget crisis’ (‘MBC’), what went right and, moreover, what went wrong. As the dust settles and trustees start to take stock, there is also an opportunity to think about ‘what happens next?’.
Trustees have, hopefully, already considered and received professional advice on the impact of gilt market movements on scheme funding positions and investment strategy.
For some schemes, market volatility and the current economic environment may also be a prompt for sponsor covenant reviews.
And, depending on the outcome of these checks, reassessment of long-term objectives and ‘end states’ may be in order. For example, has the term to buyout shortened? And, if so, is the scheme buy-out ready as regards its data and GMP rectification and equalisation?
During the MBC, many schemes will have followed the Pension Regulator’s guidance (LDI statement) and communicated with members to provide them with reassurance and remind them to be vigilant about pension scams.
With members still in mind, trustees may also want to revisit ongoing or prospective member-option exercises and consider whether they or their terms remain appropriate.
On a related note, and regardless of any incentive or other exercises, with inflation at a 40-year high and interest rates soaring, trustees should be speaking to their scheme actuary about transfer values, commutation rates and actuarial factors. Do they still represent fair value?
An easy first step would be updates to trustee risk registers; for example, in connection with operational risks relating to leveraged LDI funds and the risk that the scheme runs out of collateral to maintain the hedge. Controls / actions that could be taken to mitigate this risk might include: ensuring that the trustees’ understand the collateral waterfall arrangements in place, asking the investment consultant to include some reporting on LDI leverage in the quarterly investment monitoring reports, ensuring that the trustees’ understand the sources of liquidity, reviewing the cash management policy to ensure that it remains appropriate and ensuring that the authorised signatories list is up to date.
And, as part of ‘TKU’, trustees should also keep a watching brief on market developments. The Work and Pensions Committee (WPC) has just concluded a call for evidence on LDI, and the FCA and TPR have hinted, in evidence given to the House of Lords Industry and Regulators Committee, that minimum collateral buffers for LDI funds are being considered.
We could see a change in the way that schemes approach investment strategy too. Trustees have traditionally thought first about how much hedging they want to put in place and how to achieve it, and then thought about how to invest the rest of the assets. An alternative process could be to think about what level of return is needed and how much diversification and liquidity is required, whilst being mindful about what type of asset classes to own. So, the hedge ratio will become just one of those things and not the overriding concern that drives everything else.
One final part of the MBC fall-out is the potential for future litigation; i.e. legal disputes arising out of concerns regarding pension funds’ exposure to LDI strategies. This, however, is an article for another day and a commentator with the relevant expertise!