LDI strategies: get confident and compliant

Schemes use LDI to help ensure they will be able to meet their payments to pensioners over time. Strategies often use long-dated UK government bonds - also known as gilts - to match future liabilities. They may also use derivatives that provide additional protection (hedging) for risks such as interest rate changes.

Why did LDI strategies make the news in 2022?

In September 2022, gilt prices plummeted after the UK’s mini-Budget, pushing up the cost of maintaining hedging strategies. LDI managers asked pension schemes to make extra payments to keep hedges in place (termed collateral calls).

Many schemes were forced to sell liquid assets – equities and bonds – to meet the collateral calls. It proved an extreme stress test of trustees’ investment strategies and scheme governance.

What is the long-term impact on LDI?

That intense period of market chaos has cast a long shadow and DB trustee boards are now under pressure to make sure they are protected from future shocks.

In April 2023, The Pensions Regulator (TPR) set out five key steps for trustees to follow. These make sure they understand and are prepared for the potential risks of investing in LDI strategies. Leveraged LDI, which uses derivatives backed by collateral calls, is a particular focus.

Capital Cranfield professional trustee Mark Condron says, “Most trustee boards have a greater understanding of the detail of LDI and collateral compared to 12 months ago. Whilst there might be some different points of view on the detail, TPR’s guidance is a useful governance framework for trustees to follow.”

To respond to TPR’s guidance, trustees will need to focus on:

• reviewing the governance of their LDI strategies
• liquidity stress-testing in their investment portfolios.

Reviewing LDI governance

Bob Campion, Senior Portfolio Manager at Charles Stanley says: “Trustees need to examine their governance processes following the crisis. That means looking at how quickly they could act if we are faced with another crisis, and whether their investment portfolio has sufficient liquidity to respond to an unexpected or time-sensitive collateral call.”

A full review of LDI investment governance should involve trustees’ in-house investment teams, board sub-committees, investment consultants, fiduciary managers, as well as discussing strategy with the sponsor.

“Explore decision-making processes, board expertise and skills, the structure of sub-committees and how effective support from fiduciary managers and consultants has been,” recommends Campion.

“Identify what worked well and what didn’t. If the process wasn’t satisfactory, it’s important to discuss this with your consultant and fiduciary manager if you have one.”

For schemes using a fiduciary manager, Peter Daniels, Head of Fiduciary Manager Evaluation at Barnett Waddingham, adds: “Good governance of LDI strategies starts by ensuring your fiduciary manager has a clear set of liability hedging and liquidity guidelines, along with robust monitoring and oversight against these guidelines.”

Campion says giving fiduciary managers decision approval can be an important factor. This speeds up decision-making and ensures that the fiduciary manager can act quickly on trustees’ behalf when market conditions change.

However, Daniels adds: “It is imperative to understand the types of decisions your managers are likely to take on your behalf within your guidelines, as well as clarity on how these will be communicated.”

Liquidity stress testing

Condron says TPR’s new requirements mean that: “Trustees should be confident that they are holding a reasonable level of collateral, with the resilience to maintain protection in the event of different market movements.”

He recommends: “Don’t overlook the practicalities – for example understanding disinvestment timescales, cash transfer capabilities and ensuring that the approval lists and signatories are kept up to date.”

Condron says these areas should be tested at least annually, “and more frequently if there is a material change with the pension scheme assets or liabilities. It’s also very important that these processes are clearly documented, to ensure that future capital calls are handled efficiently.”

Key questions that trustees need to ask as part of their stress testing are:

1. What is our worst-case scenario?

Understanding how much liquid capital the scheme can raise at very short notice is crucial. This relates to the size of the liquidity buffers that trustees need to put in place, and the amount of leveraged LDI that trustees can hold.

Campion says “During the LDI crisis, we were getting 24 hours’ notice on some collateral calls. Trustees need to be aware of turnaround times for raising liquid capital, and if they would be able to respond to calls within that kind of timescale.”

2. What is our Plan B if we can’t cover a collateral call?

If trustees receive a collateral call that exceeds their liquidity buffer or has an unachievable turnaround time, they will need a Plan B. This could, for example, involve asking the sponsor for a one-off payment, negotiating with the LDI manager for a longer timeframe to raise the money, or reducing hedges temporarily or for the long term.

3. Are we using appropriate measures of risk?

Traditional Value at Risk measures used by pension schemes were turned on their head in the LDI crisis and since.

Campion says: “Schemes’ risk measures and processes must reflect current realities and market conditions. Gilt markets are still erratic and the standard perception of gilts as a safe investment has been undermined.”

4. Do we need to rebalance our portfolio?

Pressure to meet collateral calls last year may have unbalanced trustees’ portfolios, leaving them short of their target allocation of liquid assets. Rebalancing portfolios, addressing liquidity shortfalls and questioning whether illiquid assets are still suitable for the scheme all take time, but should be a priority.

With markets still uncertain, all trustees need to look carefully at their processes and portfolios to make sure they are compliant with TPR’s requirements. They will also need to take account of relevant risks and have the decision-making structures in place, possibly in association with a fiduciary manager, to make sure their scheme is prepared for future shocks.