Pensions Regulator guidance – using leveraged liability-driven investment

The Pensions Regulator has published guidance setting out practical steps for trustees of DB pension schemes to manage risks when using leveraged liability-driven investment (LDI). It covers the following areas:

• Where leveraged LDI fits within the scheme’s investment strategy.
• Operating and maintaining a collateral buffer.
• Testing the resilience of leveraged LDI arrangements to market volatility.
• Ensuring that appropriate investment governance processes are in place.
• Monitoring leveraged LDI arrangements.

The guidance replaces the Regulator’s October and November 2022 statements on managing LDI-related risk and maintaining LDI resilience in light of the gilt market volatility in autumn 2022 (for more information on those statements, please see our October and December 2022 legal updates). The guidance follows the Bank of England’s Financial Policy Committee’s March 2023 recommendation that the Regulator should specify a minimum level of resilience for leveraged LDI arrangements in which trustees invest.

The guidance only applies to leveraged LDI. However, it applies to all types of leveraged LDI arrangements i.e. pooled LDI funds, segregated LDI mandates and “funds of one”. The Regulator stresses that “[trustees] are ultimately responsible for how the assets in your scheme are invested. Your investments must be appropriate for your scheme. You must put in place the right governance and controls, and understand the risks you carry in your investment strategy.”. As such, trustees will need to consider and implement the guidance carefully.

Investment strategy

When setting and reviewing their investment strategy, trustees should understand where leveraged LDI fits within the strategy and ensure that their leveraged LDI arrangements are in line with the strategy. They should consider the benefits and risks of leveraged LDI within the wider context of the scheme and be satisfied that the level of investment risk being taken is consistent with the scheme’s funding position. Trustees should take advice and liaise with the employer as appropriate.

Collateral buffer

Trustees should ensure that the leveraged LDI arrangements in which they invest operate an appropriate collateral buffer and that the right processes are in place for drawing on and replenishing the buffer. The guidance distinguishes between two elements of the buffer:

• Sufficient liquidity to manage day-to-day market volatility (an operational buffer).
• Additional liquidity to provide resilience against severe market stress (a market stress buffer).

The operational buffer should at least reflect gilt yield volatility in normal market conditions, while the market stress buffer should be at least 250 basis points (bp). The two elements are cumulative, so the operational buffer should be added to the 250bp market stress buffer to determine the total buffer.

Regarding maintaining the buffer, trustees should understand the conditions under which calls on the buffer may be made, and put in place and record processes for meeting those calls (such as in a collateral management policy).

Testing resilience

Trustees should test the resilience of their leveraged LDI arrangements and processes. While the tests will be designed by the trustees’ investment adviser or LDI manager, trustees need to be confident that the tests are sufficiently robust and will provide them with the information they need to understand the risks associated with their leveraged LDI arrangements and processes. Trustees should record the outcome of the resilience tests and ensure that they address any areas of concern identified. Resilience testing should be carried out regularly (the Regulator suggests annually or triennially) and when there are significant changes to the scheme’s funding or investment position or in market conditions.

Investment governance

Trustees should understand how their chosen investment governance model affects leveraged LDI implementation and ensure that each party’s respective role and responsibilities are clear and appropriate to the governance model. Trustees should periodically review their appropriateness of their governance arrangements and operational processes.

Monitoring

Trustees should ensure that processes are in place for monitoring the resilience of their leveraged LDI arrangements. They should understand what monitoring their investment adviser or LDI manager performs routinely and put in place mechanisms to ensure they receive sufficient information to understand, and be able to react to, risks. Trustees should consider how frequently they should receive reports, including whether triggers should be set for any “out of cycle” reporting. They should also consider whether monitoring should be delegated to a subcommittee or adviser to ensure the trustees maintain appropriately frequent oversight of their leveraged LDI arrangements.

Comment

Trustees with leveraged LDI arrangements should review the guidance and consider what changes they may need to make to their investment and governance arrangements. Trustees should take advice from their investment adviser and, where relevant, their other advisers in this respect.

How we can help

In addition to advising trustees generally on the guidance, we can assist in particular with explaining when calls on the collateral buffer can be made and helping to document processes for meeting those calls (such as in a collateral management policy), ensuring that investment governance and monitoring requirements are clearly documented, and reviewing and negotiating amendments to LDI agreements to ensure they contain what will be necessary for trustees to comply with the guidance.

For more information, please speak to Duncan Watson or your usual Mayer Brown contact.