UK Pensions Briefing: LDI – what went wrong and what to do about it?

Introduction

Since the announcement by Kwasi Kwarteng of his “Growth Plan” on September 23, 2022, and the subsequent market dislocation (the Mini- budget Crisis), liability driven investment (LDI) strategies operated by defined benefit pension schemes have become like marmite: liked or disliked, their impact on pension scheme funding is now a very sticky matter. 

Nearly six months on from the Mini-budget Crisis, schemes, investment managers, consultants, employers, advisers, regulators and parliament are all taking a close look at the types of LDI strategies that were in place and asking questions: should LDI strategies have been in place? Was the right action taken during/ in the aftermath of the Mini-budget Crisis? Who, if anyone, may have lost out? Does LDI need tighter control? We set out below our perspective and some key reflections on the Mini-budget Crisis  and what may come next for scheme trustees and advisers.

What is Liability Driven Investment (LDI)?

In very simple terms, LDI is where schemes aim to match their assets to the promise they have made to members (their liabilities). Government bonds or ‘gilts’ are a particularly attractive investment for many pension schemes because they represent a predictable income stream over a longer term and pension scheme liabilities are calculated by reference to the yield on gilts. To mitigate interest rate and inflation risk which can increase scheme liabilities, schemes use derivative instruments  (backed by the scheme’s longer term gilt assets) to ensure that they are protected against large movements in the funding position of the scheme. In order to gain a greater market exposure than the amount of assets they have invested, schemes can introduce borrowing or ‘leverage’ to free up other capital to be invested in growth assets. This is known as “Leveraged LDI” and a requirement of this type of strategy is that schemes must post ‘collateral’ to ensure market counterparties are protected when gilt yields rise (and prices fall). It goes without saying that an LDI strategy requires trustees to take specialist investment advice and detailed processes implemented with investment managers to ensure appropriate checks and balances are in place.

What happened in September 2022?

For many years gilt yields had been relatively stable meaning schemes had well established processes in place to manage any collateral payments needed. However, over the course of 2022 and particularly following the Mini-budget announcement on September 23, 2022, the yield on gilts increased sharply and dramatically to generational highs. Whilst from a funding perspective this improved many scheme’s funding positions, for those with Leveraged LDI in place, it meant the marketplace was flooded over a very short time-frame with calls to post collateral. Whilst most schemes had collateral buffers in place, many schemes needed to sell down additional scheme assets in order to find this collateral. The immediate problem was liquidity as all of a sudden schemes and many other investors were seeking to sell gilts in order to provide the collateral. This caused a significant dislocation of the gilts markets until, on September 28, 2022, the Bank of England stepped in with a short-term pledge to buy long dated gilts and stabilise the market. 

What is the concern with LDI strategies?

LDI strategies have been common place for pension schemes for many years and are, generally, perceived to be a sensible and favourable way of mitigating risk. Indeed they have been successful for many schemes in protecting the Scheme’s liabilities against significant market movements over a long period. There is however no requirement (currently) to asset match, or have LDI and, at heart, many Leveraged LDI strategies involved capital backed borrowing or betting on interest rates remaining stable. When interest rates rose sharply after the Mini-budget Crisis, schemes had to sell longer termed gilts to meet cash requirements meaning some schemes had to sell assets they would otherwise have wished to retain to meet collateral calls or the amount of protection or the ‘hedge’ they thought they had in place was reduced. Inevitably, this raises the question as to whether trustees, investment managers or consultants who ‘sold’ LDI strategies to pension schemes may be open to criticism or risks of claims in respect of any losses which schemes may have been suffered.

No one size fits all: there was no uniform approach in the Mini-budget Crisis - and that may be ok.

LDI strategies are not “wrong”, and a Leveraged LDI strategy is not necessarily inappropriate for a scheme. What is right and appropriate will for each scheme depend on different factors, scheme maturity, funding, strength of the employer, availability of employer cash flow, all manner of factors as the DWP and the Pensions Regulator are telling us are material to a schemes Funding and Investment Strategy. It is now reported that the immediate response when gilt yields peaked was for investment managers to take one of four actions: (a) call for additional capital, (b) reduce leveraging in place, (c) suspend trading, or (d) do nothing.

Each scheme is different, and scheme investment managers therefore responded to the Mini-budget Crisis differently. Some information on the experience of pooled Leveraged LDI funds has shown that where managers managed the collateral pool to maintain leverage and had automatic recourse to additional capital and liquidity, they rode the storm out well. For other schemes, questions have been raised as to whether governance arrangements were: a) followed as they should have been; and b) appropriate, to allow schemes to react in a timely manner to what was material and sudden market turbulence, requiring rapid counter-action.

Going forward, schemes with Leveraged LDI strategies will need to consider reviewing capital requirements, automatic lines of credit, and asset liquidity. Claims, if any, will depend on the circumstances of each scheme. They will be highly fact specific and will depend on details such as the contracts in place, investment delegations and instructions, if mandates were followed and the actual information available to the adviser at the relevant time – as well as the decisions taken.

The Mini-budget Crisis was not anticipated and is acknowledged as the first event materially testing Leveraged LDI strategies. It raises concerns that Leveraged LDI strategies were not appropriate for certain schemes.

We are seeing a rise in literature since the Mini-budget Crisis setting out detailed instructions for schemes, managers, consultants and advisers relating to Leveraged LDI strategies.  Recommendations range from keeping Leveraged LDI strategies under review, completing and/or improving stress testing, putting collateral management plans in place, and considering decisions taken during the Mini-budget Crisis. Key decisions to review include matters such as the instructions given to managers to sell scheme assets to provide collateral, the permissions given to cut back leverage, and assessments as to what the alternative would have been to the actions taken.

That these recommendations are made now suggests that they may not have been prioritised by the industry generally before the Mini-budget Crisis.  

In this context, it is perhaps contrived now to call out for example an investment manager or investment consultant without clear cause and say that did not act competently, or that they were responsible for scheme losses. Any party contemplating any claim relating to the Mini-budget Crisis should consider (contractual responsibility aside) that the object of tortious claims is to put the claimant into the position had the negligence not occurred, and so potential damages would be assessed according to objective standards  and the evidence available at the relevant time. Claims are unlikely to be successful when assessed against hypothetical standards or knowledge derived from hindsight. It may even be possible to argue that as a “first event” the Mini-budget Crisis was unforeseeable and respondent losses therefore so remote that those who implemented instructions and made decisions cannot be held responsible. Indeed, as mentioned above, many schemes have successfully used LDI to protect  against inflation and interest rate risk over many years and the impact of any losses due to the Mini-budget Crisis may not be capable of being viewed in isolation against that context.

Contracts are key. The terms of managers and advisers’ service contracts are likely to set out their duties, how instructions are to be provided and implemented and limits and exclusions on liability.

Where terms are favourable to managers, consultants and advisers or they have not been externally reviewed at inception it will be more difficult to successfully argue that advice provided prior to the Mini-budget Crisis is in breach of contractual terms. Additionally, mandates ordinarily include flexibility to make such decisions in extenuating circumstances and stark warnings that investments can go up as well as down. Importantly, whenever day-to-day investment decisions are delegated the trustee remains responsible for the investment strategy which managers implement. For any claim that managers have breached their contractual obligations to succeed, it would need to be demonstrated that they have not exercised delegated investment powers appropriately, and in accordance with the Statement of Investment Principles, instructions and broader mandate. 

Leveraged LDI is permissible, accepted practice and arguably pragmatic (albeit lacking regulation).

A recent letter from the House of Lords’ Industry and Regulation Committee to Ministers highlights that Leveraged LDI strategies were often used to mask the fact that when interest rates fell, the discounted value of future liabilities rises. This would potentially show a scheme deficit that would need to be recorded in the employer’s accounts, which sponsors and trustees sought to avoid. It is clear that the House of Lords’ blames the Mini-budget Crisis on this ‘artificial problem’ created by pensions accounting standards. It is also clear however that Leveraged LDI strategies were permissible and a widely and generally accepted practice and used appropriately by many schemes as part of pragmatic scheme management. 

The letter is critical of the industry-wide approach to Leveraged LDI as it has evolved and, on review of the practices the committee has identified, directs the government to look further at those practices. It recommends that if Leveraged LDI is to continue to be permissible then stricter rules are required: it suggests that reporting requirements and liquidity buffers should be introduced, investment consultants should be regulated on Leveraged LDI strategies (and trustees required to take regulated advice), and regulators must monitor and ensure that schemes stress test.  

The breadth of the proposed regulation demonstrates the limited statutory framework which was applicable prior to and at the time of the Mini-budget Crisis and there is a clear indication that stricter rules on use of LDI strategies may arise in the future. 

Conclusions

We will continue to monitor this developing area. So far, the mooted deluge of claims from some industry commentators has not arrived and it may be that any potential claims sought to be brought against advisors and trustees or brought by trustees and employers relating to the LDI crisis could face practical difficulties in terms of establishing the elements of a claim (i.e. breach of duty, causation, loss). There may, however, still be scheme specific circumstances which enable this or claimants who are willing to put that to chance. Norton Rose Fulbright LLP has put together a cross-practice team of technical experts to assist clients on any issues relating to this highly topical area, whether reviewing existing LDI arrangements or dealing with/investigating any complaints. Please reach out to your usual Norton Rose Fulbright contact if you have any questions in this regard.