The House of Lords Industry and Regulators Committee has
criticised the use of leveraged liability-driven investment (LDI)
strategies by defined benefit (DB) pension funds, which played a
significant role in the financial turmoil following the September
2022 fiscal statement.
In a letter today (Tuesday 7 February) to MP, Economic Secretary to
the Treasury, and , Minister for Pensions, the
Committee raises concerns that regulators had not focused
sufficiently on the risks and dangers that borrowing to boost
investment returns could pose to pension scheme finances, and
wider financial stability in the event of interest rates rising.
The sharp rise in interest rates in September forced pension
funds to sell assets, often at significant losses, in order to
meet the liquidity calls required by the fall in leveraged LDI
values.
The letter outlines the Committee’s findings of its scrutiny
work, during which it heard from industry and regulatory
representatives including Legal and General, the Financial
Conduct Authority, The Pensions Regulator, and pensions experts.
It found that:
- liability-driven investment strategies, particularly those
that use leverage, were created as a solution to an artificial
problem created by accounting standards, which drive sponsoring
companies to focus heavily on current, rather than long-term,
estimates of pension deficits. Pension schemes aimed to hedge
volatility in these estimates by investing in bonds, but due to
the low returns these offered and the need to close their
deficits, they borrowed to boost their returns.
- the use of borrowing and derivatives for these purposes is
not permitted by the relevant underlying EU legislation, which
appears to have been permissively transposed in the UK in order
to allow pension schemes to continue using such strategies.
- it is likely some pension scheme trustees were not aware of
the potential implications of their LDI strategies and their
decision-making struggled to match the pace of markets. This has
led them to become dependent on advice from investment
consultants, whose advice to schemes is currently unregulated and
may not be comprehensive over the whole portfolio or cover
operational requirements.
- despite calls for more information and a review of stress
tests from the Financial Policy Committee, regulators in the
sector appear to have been slow to recognise the systemic risks
caused by the concentration of pension schemes’ ownership of
assets such as index-linked gilts, and the increasing use of more
complex, bank-like strategies and instruments by pension
funds.
In the letter, the Committee calls for action to improve
regulation and reduce the risk of similar disruption in the
future. It recommends that:
- the Government and the UK Endorsement Board should review
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. More schemes should be allowed to take an asset-based
approach if this is appropriate for them.
- the Government should review the relevant regulations and
consider whether the use of repos and derivatives should be more
tightly controlled and supervised in 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.
- the Government should ensure that investment consultants are
brought within the regulatory perimeter as a matter of urgency.
Following this, regulators must have heed to the non-professional
nature of trustees in their regulation of consultants and ensure
consultants are liable for their advice. Regulators should ensure
they have more information on the leverage present within pension
scheme finances and that stress tests are conducted. The
Government should consider giving the Prudential Regulation
Authority a role in overseeing pension schemes.
- 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. 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.
, the Chair of the Industry and
Regulators Committee, said:
“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.”
