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Maintaining liability-driven investment resilience

Published: 30 November 2022


The turbulence in longer-dated UK government debt in late September exposed shortcomings in the resilience of liability-driven investment (LDI) funds, as well as in the operational processes of the funds and of pension schemes investing in them. In particular, the ability to raise liquidity in a timely manner was an issue for a number of schemes. This created risks for pension schemes of losing the effectiveness of their hedge during a period of high volatility. It also created the potential for wider impacts on the orderly functioning of the economy.

Following our statement ‘Managing investment and liquidity risk in the current economic climate’ in early October, we are issuing this guidance to defined benefit (DB) pension scheme trustees and advisers to set out recommended actions in light of recent events in gilt markets. These actions aim to:

  • achieve and maintain an appropriate level of resilience in leveraged LDI funds across pooled and segregated arrangements to withstand a fast and significant rise in bond yields
  • improve operational governance of pension schemes

We welcome the statements by the Central Bank of Ireland (CBI – Ireland) and the Commission de Surveillance du Secteur Financier (CSSF – Luxembourg) (collectively the National Competent Authorities or NCAs) on resilience of LDI funds published on 30 November 2022.

We acknowledge their expectation of maintaining a specific level of liquidity buffer along with the reduced risk profile, given the recent higher level of market volatility and future uncertainty, and the current geo-political landscape.

Where statements from the NCAs refer to pooled funds, we believe the same level of resilience should be maintained for segregated leveraged LDI mandates and single-client funds, as they face the same market risks and operational challenges. If a scheme is not able to hold sufficient liquidity, or is unwilling to commit to that level of liquidity, they should consider their level of hedging with their advisers to ensure they have the right balance of funding, hedging and liquidity. For schemes that decide to adopt an investment strategy with a reduced hedge, this should be done in a predetermined manner by the trustee, having taken appropriate advice. 

Next steps for trustees

The trustees of the scheme are responsible for testing the liquidity buffer as per the steps below, but it is likely that they will ask their advisers to do the calculations and provide the necessary advice.

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, including how it will raise liquidity - taking into account that the ability to sell assets in such conditions may be greatly impaired
  • detail a step-by-step plan for bringing the scheme to higher levels of resilience in the event of volatility returning to the market, noting any assumptions in respect of market conditions, operational arrangements and timescales that the plan is based on
  • document these arrangements and review regularly

We recommend that trustees review their governance processes and consider the challenges that arose for their pension scheme during the volatility in September and October 2022, and then consider what practical steps in terms of their arrangements (or other governance considerations) they can implement as a result of lessons learned.

We recommend that trustees take the following practical steps (where relevant to their scheme) to ensure they are able to react quickly in response to stress in the market:

  1. Confirm authorised signatories are up to date and ensure that governance is sufficiently robust, and that decisions can be made at speed in stressed market conditions.
  2. Stress the non-leveraged LDI asset allocation (eg equities, corporate bonds) using a yield shock as set out by the NCAs.
  3. Stress the leveraged LDI pooled fund / segregated mandate using the same yield movement.
  4. Calculate the required collateral amounts, and the type of assets (for example, gilts, cash).
  5. Specify the dates when these collateral / margin calls need to be made.
  6. Specify what assets would be sold, when the sell instructions would need to be given, and when the cash is settled.
    • This should take account of the settlement period of the various asset classes or the dealing dates of pooled funds and any potential risk that any fund may defer redemption if they are unable to meet liquidity needs, or become considerably less liquid in such conditions.
    • Trustees should liaise with LDI fund managers and ask for an assessment of the liquidity of the assets that the schemes intend to use to meet cash requests.
  7. Confirm who the instructions need to go by and the method of signature (electronic or wet ink).
  8. Confirm that necessary collateral / cash margins can be paid on the dates specified.
  9. Confirm the asset allocation post collateral / margin call.
  10. Document these arrangements and review them regularly.

We also recommend that trustees continue to have detailed conversations with LDI managers on liquidity for pooled and segregated arrangements, including:

  • what the triggers for replenishment are
  • confirming the process for meeting collateral / margin calls
  • providing visibility of liquidity to LDI managers as appropriate

Alternatives for DB schemes with a line of credit with their sponsoring employers

Schemes may prefer to establish a line of credit with their sponsoring employer to ensure liquidity. Such arrangements should be documented and reviewed regularly to ensure they remain in place and clearly reference the time period, amounts and conditions. The emphasis should be on immediate flow of cash if required. When such arrangements are in place, this line of credit can be used in place of investment liquidity. Any facilities must only be utilised on a short-term basis and for liquidity purposes.

Trustees should make sure any arrangement is reviewed legally to avoid the risk of an abrupt end to the facility when it is needed.

Next steps

The purpose of this guidance is to address immediate requirements on liquidity. We are alive to the constantly changing market conditions and the implications for the future and we continue to discuss this issue with a number of external stakeholders with a view to providing clear longer-term expectations in this area. We plan to issue a further update in our Annual Funding Statement in April 2023 and in further statements and investment guidance as necessary.