The Financial Conduct Authority (FCA) and The Pensions Regulator (TPR) have laid out their expectations on the future of liability-driven investment (LDI), mapping out how the market needs to evolve.
TPR has introduced a new minimum 250 basis points (bps) buffer, which must have scope to be replenished within five days. It also wants to see an operational buffer sufficient to cover day-to-day volatility.
This is a direct response to the crisis created by last year’s LDI debacle, which had a huge impact on pension funds.
An operational buffer of 100bps was the standard methodology, and the conclusion reached is this is no longer satisfactory.
This could potentially have a big impact, said Sinead Leahy, managing director at Cardano, the investment management firm behind Now Pensions.
“TPR guidance regarding collateral buffers will mean that some pension schemes will need to review their return objectives and level of hedging, as it won’t be possible to continue hedging to the same degree and target high returns and meet the new collateral guidance. Choices will need to be made,” she added.
The FCA set out a clear theme of greater accountability through-out the decision-making chain in relation to LDI and other similar investments.
LDI managers must be satisfied that the choice of investment is suitable for the investor in the context of their intended outcomes and wider arrangements.
The FCA explicitly mentions considering the benefit of segregated versus pooled funds, recognising how the operational flexibility of segregated funds was advantageous during last year’s crisis.
More information
Furthermore, LDI managers will need to obtain detailed up-to-date information about a scheme’s wider arrangements, which would typically be greater than is readily available in the scheme’s Statement of Investment Principles.
However, it is not clear at this stage how any new responsibility on LDI managers will be monitored or enforced.
A natural implication is that there will be some level of increase in client servicing.
If this went as far as the LDI manager having a duty of care on the end investor, this could also increase risk for the LDI manager.
These factors may well result in higher fees charged to pension schemes to compensate the manager – a point that will not please asset owners.
Simeon Willis, chief investment officer at consultancy XPS Pensions, said a theme running through the FCA announcement was one of all participants sharing greater responsibility for LDI arrangements.
“A higher bar is being set,” he added. “It’s clear that a siloed approach from investment manager or investment adviser, narrowly focused on their own role alone, is insufficient to meet expectations.
“Everyone involved in the decision-making chain should be demonstrating that they are considering the suitability of the investment for the end investor and the resilience of that investor’s overall arrangements.”
This means, Willis added, that LDI managers will need to ask questions about what a client is trying to achieve by investing in the LDI fund. “So, it can satisfy itself and evidence that the fund is the best approach all round,” he said.
These outcome focused developments mirror the messages that have emanated from discussions around the responsibilities of regulators themselves. For example, the Bank of England’s recommendation that TPR set an additional objective around financial stability.
Covering the cracks
This overlapping approach has been proposed as a means to ensure key matters of systemic importance don’t slip through the cracks. For all involved, particularly investors, this is no bad thing.
Sinead Leahy added that LDI has to be looked at in a wider historical perspective, and not just in reference to the crisis of late last year.
In such a context, LDI has served, Leahy said, as an invaluable tool for pension schemes for the past 20 years, resulting in many schemes being in stronger funding positions and with lower dependencies on their sponsoring company.
“Overall, the system and use of LDI is not broken and what we saw at the end of last year was an extreme event that was not foreseen by the market,” she added. “However, there have definitely been winners and losers. And so, it is important that trustees and sponsors effectively run a ‘health check’ on their mandate.”
But the path set out by the regulatory bodies will change the LDI game.
“Unfortunately, you can’t have your cake and eat it,” Leahy said. “As the FCA and TPR guidance says, the focus should not just be on collateral management and governance but also look at the operational side of the overall LDI mandate – how is the process managed, monitored and acted upon.”
Therefore, Leahy recommended a checklist for investors: a review of operational resilience and governance is essential together with the need to revisit journey plans, desired end-game options based on the funding position, hedging and leverage positions, and updating growth asset outlooks.
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