Following the mini-Budget in September 2022, Gilt yields rose rapidly, leading providers of Liability-driven Investment (“LDI”) vehicles to require more collateral. The Bank of England stepped in to calm the market, announcing a programme of Gilt purchases. While this calmed markets initially, participants remained worried about what would happen when the Bank’s support ended on 14 October so, in the first half of October, calls for additional collateral were made every few days, requiring the extra funds at very short notice.
On 12 October, the Pensions Regulator (TPR) issued guidance for pension schemes on managing investment and liquidity risk. It acknowledged that LDI has been very helpful in enabling schemes to manage their interest rate and inflation; indeed, TPR has often encouraged schemes to invest in this way. The guidance acknowledges also that most schemes have maintained liquid funds to be used for collateral when required, which have been sufficient to meet such demands to date. However, the speed at which collateral was required in September and October meant that schemes were scrambling to replace their liquid assets to meet the next call. Some schemes, therefore, lost some of their hedge.
TPR suggests that trustees should review their:
- operational procedures:
- would a professional trustee help?
- having contingency plans to enable them to adapt quickly,
- governance processes for the buying and selling of investments,
- liquidity position:
- understand sources of liquidity and review any liquidity waterfalls,
- review the balance of liquid investments,
- explore whether the employer could provide temporary liquidity,
- liability hedging position:
- leverage has fallen in most funds, so hedging levels will have fallen as well,
- funding and risk position:
- depending on the level of hedging, funding levels may have improved, allowing some de-risking.
Further guidance arrived on 30 November, from both TPR and the “National Competent Authorities” (the Central Bank of Ireland and the Luxembourg Commission de Surveillance du Secteur Financier). The National Competent Authorities set out their expectation of pooled LDI funds maintaining a specific level of liquidity buffer along with a reduced risk profile. TPR extended this to segregated and single-client funds, recommending that, where schemes are not willing to commit sufficient liquidity to support their LDI, they should reduce the level of hedging.
The guidance states that, if trustees depart from the liquidity buffer set out by the NCAs, they should:
- work with their advisers to demonstrate the buffer the scheme has in place,
- complete a risk assessment of how the scheme will respond to stressed market events so that the scheme remains resilient during these events,
- detail a step-by-step plan for bringing the scheme to higher levels of resilience in the event of volatility returning to the market and
- document these arrangements and review them regularly.
It recommends that trustees review their position and processes, including:
- stress-testing the non-LDI assets (eg equities, corporate bonds) against a given rise in yields,
- stress-testing the leveraged LDI holding using the same yield movement,
- calculating the required collateral amounts and the type of assets (for example, Gilts, cash),
- specifying the dates when these collateral calls need to be made and
- specifying what assets would be sold, when the sell instructions would need to be given and when the cash would be settled.