On 24 April 2023, the Pensions Regulator (TPR) published important new DB trustee guidance on leveraged liability driven investment (LDI) designed to address issues arising out of the September/ October 2022 gilt market volatility. Here we summarise the key actions and main points.
TPR’s LDI guidance
TPR’s latest LDI guidance follows the Bank of England’s Financial Policy Committee’s 29 March 2023 statement (see the Insight produced by our colleagues in the Gateley Legal pensions team). It replaces TPR’s October 2022 statement and November 2022 guidance (see Gateley’s Insight).
LDI within the investment strategy
This part of the guidance helpfully pulls together how trustees’ existing investment duties should operate in the context of LDI. Trustees must be clear on where LDI fits within a scheme’s investment strategy, reviewing the strategy regularly and after significant changes. The guidance sets out certain factors that trustees should consider when considering this. Changes to the investment strategy should be documented.
Knowledge and understanding
Trustees must have adequate knowledge and understanding of LDI, when to take advice and which investment activities can or must be delegated. Advisers will be able to assist with any training needs.
Trustees must set, operate, and maintain a “collateral buffer”, a reserve which can be used by the fund manager if additional collateral is required when market conditions change. Both an “operational buffer” for day-to-day fluctuations and a “market stress” buffer for ‘severe market stress’ are needed to maintain resilience.
TPR has adopted the Financial Policy Committee’s recommended market stress buffer of at least 250 basis points – this “should be maintained in normal times but can be drawn upon in periods of stress”.
The market stress buffer should be capable of being replenished within five days (if longer, a larger buffer may be needed). A larger market stress buffer may be needed at other times as well – for example, if the assets held are more volatile than those typically held in a buffer.
The market stress buffer operates in addition to the operational buffer – for example, if the former is 250 basis points and the latter 100, the total buffer will be 350 basis points.
The trustees need to satisfy themselves as to the adequacy of the buffer and its operational effectiveness. Pointers are provided by TPR on assessing the appropriateness of the buffers.
Maintaining the buffer
Trustees need to understand when ‘cash calls’ may be made to maintain the buffer, how these will be met and document the processes. Relevant considerations for which assets should be held in the buffer include selling time, and the impact of stressed market conditions on the liquidity, availability, and value of the asset.
There should be sound and regular (perhaps annually or triennially) testing for resilience, particularly in respect of collateral. Testing should also be carried out after significant funding, investment, or market condition changes.
Although the LDI managers will formulate these tests, trustees need to satisfy themselves that they are sound and that they understand the risks. The test results should be documented with any concerns identified subsequently addressed.
The guidance covers the two ways in which resilience testing can be carried out: (1) considering performance under different scenarios relevant to the investment strategy and vulnerabilities; and (2) ascertaining the market movement size needed before a particular event would happen such as a call to replenish the buffer.
LDI resilience needs to be monitored. Trustees will need to liaise with advisers to ensure that they have appropriate oversight of the monitoring that LDI managers carry out. TPR’s guidance provides useful examples of the type of information that trustees may find helpful in this regard:
- the value of LDI assets
- the value of the assets available to meet cash calls
- the value and liquidity of assets earmarked for cash calls
- the size of the operational and market stress buffers and how these compare to recent and long-term market volatility
- the size of market movement which needs to take place before the next collateral calls would need to be made, and how large these calls would be
- if any collateral calls have been made – which assets were sold, the price achieved for these assets, and how the processes performed – for example the time taken to meet the cash call
- whether hedging has been lost or reduced during the reporting period, and the impact of this
- reminders of the timelines for meeting cash calls to LDI arrangements
- reminders of the dealing cycles of assets identified to meet cash calls.
In addition to the regular cycles of reporting, trustees may need to ask that information is provided when specific triggers are met and when markets behave unusually.
Trustees need to make sure that:
- the scheme has appropriate governance and operational processes to effectively manage the scheme’s LDI reflective of the investment governance model adopted and the services that advisers/ managers provide; and
- that the processes are suitably documented and periodically reviewed.