Taking stock after the LDI liquidity crisis – Our 20 point action list

• United Kingdom

• Pensions

29-11-2022

The events leading up to the LDI liquidity crisis following the Government’s mini Budget in September are well documented and generally well understood.  The current challenge for schemes is to decide what they should do next.  This Speedbrief sets out 20 actions which we think schemes should be considering based on our experience of working with clients over the last few weeks. 

The action list is divided broadly between operational and governance considerations and actions which are more tactical or strategic.  Many of these actions are likely to require advice from the scheme’s investment consultants and legal advisers and will depend on the individual circumstances of each scheme.

Operational considerations

1. Understand exactly what happened to the scheme’s hedging level, funding position and asset allocation following the mini Budget, what decisions were taken and by whom, and how this was documented and reported to the trustee board.  This should be a factual assessment supported by complete transparency from managers and consultants.
2. Speak to investment consultants to understand what asset allocation currently looks like and what movements are expected in the next few months.
3. Speak to investment consultants about whether and how to rebuild liquidity to support future collateral calls – many schemes used up their available liquid assets quickly following the first calls for collateral after the mini Budget, so trustees should ensure that they have rebuilt sufficient liquidity to ensure future collateral calls can be met while the position is reviewed and other operational, tactical and strategic steps are considered.
4. Speak to investment consultants about whether there is a need to recalibrate the scheme’s liquidity waterfall – a particular challenge schemes faced in the days of trading immediately after the mini Budget was that assets that were typically considered liquid (such as weekly dealt funds) were simply not liquid enough.  Schemes may therefore wish to consider whether there needs to be a change to the assets earmarked to provide liquidity and whether certain assets are appropriate for this purpose at all in the times of market stress in which they are needed.
5. Consider widening LDI managers’ access to other assets – in its guidance in October, the Pensions Regulator suggested that schemes should consider granting LDI managers a power of attorney so that they are authorised to access assets outside the collateral pool in order to provide liquidity.  We have seen schemes consider this where, for example, an LDI manager also runs a non-LDI mandate (such as a diversified growth fund) for the scheme.  Trustees should give careful thought to the advantages and disadvantages of granting their LDI managers access to further assets and fully understand the terms on which the LDI manager would operate and be liable for any errors.
6. Speak with investment consultants and LDI managers about whether LDI remains right as a strategy and, if so, the right level of hedging and leverage/collateral buffer within the LDI mandate.  Many pooled LDI funds took steps to increase collateral buffers in the period during which the Bank of England temporarily intervened in the gilt market.  Typical steps taken were to raise collateral buffers (thus deleveraging the hedge) so that a 300 basis point increase in yields could be withstood (as opposed to an increase of around half that before the mini Budget).
   
   Governance considerations
   
   
7. Consider the efficiency of schemes’ investment processes – this includes the process for making decisions on matters such as disinvestment and hedge maintenance, as well as procedural steps such as the signing of disinvestment instructions by authorised signatories.  While there has been commentary that trustee boards with more delegated arrangements in place (such as fiduciary management) were better placed to react to the market challenges, such schemes will still wish to understand thoroughly what decisions were taken.
8. Don’t forget about the Statement of Investment Principles – many schemes will have found that the dislocation in the LDI market, and the necessary response to that, has caused their investment strategy to deviate from that set out in their SIP.  Where this has been the case, and a decision is taken to maintain the deviation, the SIP will need to be updated – this will require consultation with the sponsor.  It’s also important to remember that, where there is a significant change in investment policy, this will trigger a requirement to review the objectives trustees have in place with their investment consultant under the new regulations which took effect on 1 October 2022.
9. Consider the need for training – where a trustee board feels it could benefit from a greater level of understanding in relation to LDI, or investment or risk-management generally, it should consider whether it can access training from its existing investment and legal advisers.  Trustees might feel there would be benefit in seeking such training from a firm they don’t currently work with in order to gain a fresh perspective on this area.
10. Review the risk register – for many schemes there are some important questions around how the risks arising from “high-impact low-probability” events should be planned for and managed, and also some questions around whether unjustified complexity or opacity in an investment strategy and/or excessive reliance on advisers is itself a source of risk for the scheme.  A key consideration is whether the controls in the risk register worked as intended and, if they did not, whether different or additional controls should be put in place.
    
    Tactical considerations
    
    
11. Consider with investment consultants the implications of a deleveraging by LDI pooled funds – it has been widely noted that many managers of LDI pooled funds have taken steps to reduce the level of leverage operated in their funds since the mini Budget.  The immediate question this gives rise to for trustee boards is whether hedges should be topped up to preserve the pre-existing level of asset-liability matching or whether a reduction in hedge ratio is acceptable given investment opportunities elsewhere across the portfolio.
12. Widening eligible collateral definitions – one of the principal causes of schemes’ difficulties in meeting collateral calls to support their LDI arrangements was the fact that collateral had to be posted in cash. Typically gilts are also acceptable collateral, but most schemes do not hold surplus gilts outside their LDI strategies.  A number of schemes have been engaging with their swap counterparties to amend their trading documents to permit other assets to be posted as collateral (such as investment grade corporate bonds). This may be something that LDI managers can do for trustees or it may require negotiating amendments to existing contracts directly with counterparties.
13. Extend timescales for posting collateral – as well as reviewing trading documents to seek to widen the categories of asset that count as eligible collateral, schemes have also sought to extend the timescales within which collateral has to be posted.  Such changes are unlikely to be possible in respect of pooled funds, but schemes with segregated LDI mandates may be able to persuade their swap counterparties to make some adjustment in this area.
14. Obtain access to a source of external liquidity – it has been well-documented that a number of schemes have entered into short-term borrowing facilities with their sponsor in order to provide them with a temporary source of liquidity to bridge the short-term market turbulence.  Not all sponsors have been able or willing to agree to such requests, and some schemes have sought borrowing facilities with banks or custodians, but having such a facility in place can be useful in enabling strategic allocations to be preserved.
    
    Strategic considerations
    
    
15. Review investment consultant and LDI manager’s performance – the majority of schemes will be reviewing their investment consultant’s objectives and performance against them at this time, but many will want to take the opportunity to consider the quality of advice provided on the setting of LDI mandates and the management of liquidity risks, as well as the service provided during the recent crisis.  Some schemes may also wish to review their LDI manager and the continuing suitability of its offering at the same time.
16. Identify any opportunities that have arisen – all else being equal, increased gilt yields mean lower liabilities for the typical scheme, so an insurance transaction for all or some scheme liabilities may have become achievable or within reach.  In this case, schemes typically consider shifting into assets that match insurer pricing.  Similarly, schemes may consider that a fall in the cost of hedging presents an opportunity to introduce or increase hedges.  And a reduction in leverage ratios could allow capital to be allocated elsewhere as part of a diversified portfolio.
17. Consider other ways of matching liabilities – schemes of a large enough size may consider that the increased expense of investing in a segregated LDI mandate are justified due to their experience of using a pooled fund approach – and a more precise hedge can be achieved this way in any case.  Other schemes may consider that it is preferable to hold gilts and investment grade corporate bonds directly to achieve a cashflow match (for benefit payments), as distinct from controlling funding levels by having synthetic and leveraged exposure to gilts through swaps.
18. Reassess the calculation of the discount rate – while most schemes adopt an approach of calculating the present value of their future liabilities by reference to the expected yield on UK government bonds, a possible alternative approach is for the discount rate to be calculated by reference to the expected return on assets.  This alternative approach has been recognised by the Pensions Regulator and is advocated by certain actuarial consultants, but is clearly an actuarial matter.
19. Where loss has been suffered as result of the recent gilt market volatility, consider whether any actionable claims have arisen.  Some schemes may consider that the services provided by their investment consultant and/or the steps taken by their LDI manager (including a fiduciary manager) potentially fell short.  Areas to look at include the suitability of the investment, the advice given in relation to market movements in the run up to September, the speed at which updates were provided and/or instructions sought and the exercise of any contractual discretions in relation to funds.  In such circumstances, trustee boards will need to take legal advice as to how such claims are assessed, raised and addressed with the respondent party.
20. Keep a watching brief on the Work and Pensions Select Committee’s investigation into the LDI crisis.  We have already seen statements issued by the Pensions Regulator and FCA in relation to the investigation and surrounding issues.  It is possible that further recommendations and guidance in relation to LDI will come out of the Select Committee’s investigation that are relevant to future investment decisions.  It is also worth learning lessons from other schemes and asking advisers about their experiences as the industry works through this together.