Leveraged LDI pensions strategies ‘worsened last autumn’s financial turmoil’

The Pensions Regulator should be given a duty to consider the impact of the pensions sector on the wider financial system, according to a House of Lords Committee.

The Industry and Regulators Committee criticised the use of leveraged liability-driven investment (LDI) strategies by defined benefit (DB) pension funds, which it said played a significant role in the financial turmoil following the mini-budget in September.

DB pension schemes promise to pay pension savers a set amount in the future, over the course of their retirement.

In a letter to Economic Secretary to the Treasury Andrew Griffith and Pensions Minister Laura Trott, the committee raised concerns that regulators had not focused sufficiently on the risks and dangers that borrowing to boost investment returns could pose to pension scheme finances, and wider financial stability in the event of interest rates rising.

The letter says: “The Pensions Regulator should be given a statutory duty or ministerial direction to consider the impacts of the pensions sector on the wider financial system.”

It is likely some pension scheme trustees were not aware of the potential implications of their LDI strategies and their decision-making struggled to match the pace of markets, the committee said.

The committee also called for a review into whether the current system of accounting for pension scheme finances in company accounts is appropriate and whether to introduce a system that does not drive short-termism in pensions investment.

The letter adds: “It is clear that the main driver of the increasing use of LDI, and particularly leveraged LDI, by DB pension schemes has been changes in accounting standards, which have introduced a sense of short-termism to what should be long-term investment strategies through the regular measurement of the present value of liabilities on company balance sheets.”

Committee chairman Lord Hollick said: “The evidence we heard overwhelmingly suggests that the use of LDI strategies caused the Bank of England intervention.

“If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction, rather than a downward spiral in Government debt markets that threatened the UK’s financial stability and led to significant losses as pension fund assets had to be sold in order to meet LDI liquidity requirements.

“The impacts of accounting standards and the widespread adoption of leveraged LDI have transformed pension schemes from being long-term institutions into ones focused mainly on short-term volatility in prices and interest rates.

“We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the Government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes.

“This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again.”

“Individual pension schemes may well have made decisions that made sense in isolation but these had knock-on impacts for the financial system as a whole, and this is an area where closer regulatory oversight would have led to a less bumpy ride.

“However, the Bank of England already has a role to look at system-wide issues such as this, and, working in partnership with the Pensions Regulator could be tasked with making sure that the system as a whole is less vulnerable to shocks going forward.

“I am however sceptical that the underlying cause of these problems was the accounting rules which apply to pension schemes. Pensions schemes decide their investment strategy primarily on the basis of the law and regulations which come from the Government and the Pensions Regulator, and it was this framework which was the primary driver for the use of leveraged LDI in the first place.”

A spokesperson for the Pensions Regulator (TPR) said: “We note the committee’s recommendations and are already taking action to learn lessons and address many of the issues raised, while operating within the scope of our statutory objectives. We will work with our key partners to consider other areas of focus set out by the committee.

“Through guidance released in October and November last year, we have clearly set out how we expect scheme trustees to improve the resilience and governance of their LDI holdings in a number of areas.

“We will continue to work with our regulatory partners, including the FCA (Financial Conduct Authority) and overseas regulators, to monitor compliance with these minimum standards, and take co-ordinated action where necessary if they are not being met.

“Adequate monitoring of resilience will require enhanced data collection, and TPR is actively considering how to expand our collection of data on LDI arrangements and consequent liquidity buffers.”

A Government spokesperson said: “We are committed to working with industry and regulators to monitor the financial system, ensuring a robust regulatory approach that improves resilience to market shocks.

“We will respond to the Lords committee’s letter in due course.”

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