The October 2022 LDI crisis caught many in the pensions industry by surprise as trustees and their corporate sponsors rushed to shore up their schemes’ financial positions, when certain pension schemes which had invested in LDI (liability-driven investment) strategies were faced with urgent collateral calls due to a sharp rise in gilt yields.
Now the industry is turning to focus on why and how it happened, and what happens next.
New regulatory guidance on the use of LDI funds
The Financial Times recently reported that, in a hearing of the House of Lords’ industry and regulators committee on 15 November, the FCA admitted that it had not been prepared for the impact of the sudden movement in the gilts market on pension schemes due to their LDI strategies, and that it was considering imposing stronger safeguards on LDI funds, including leverage caps and higher capital buffers. Further, the chief executive of the Pensions Regulator (TPR) told the committee that TPR would be having a “real, real focus” on LDIs in future.
On 30 November, TPR followed that statement by issuing guidance on the use of LDI funds, in which it:
- makes clear that it expects schemes to meet a recommended liquidity buffer for segregated and single-client LDI arrangements;
- recommends to trustees that if they depart from the recommended liquidity buffer, they should take appropriate advice, including conducting a risk assessment as to how the scheme will respond to stressed market events, and preparing a step-by-step plan for improving the scheme’s resilience to market volatility. The risk assessment and step-by-step plan should both be documented and reviewed regularly;
- recommends to trustees that their governance processes should be reviewed in light of the LDI crisis, and that practical steps are taken to improve the trustees’ ability to act quickly in response to stressed market conditions. This includes calculating and stress-testing exactly how future collateral calls would be met if required, as well as determining the procedure for signing off on instructions to the investment managers; and
- encourages schemes to consider, as an additional protection, establishing a line of credit with their sponsoring employer to ensure that liquidity is available on a short-term basis if needed.
In view of the new guidance, pension trustees and their advisers will be expected to scrutinise and stress-test their use of LDI funds much more robustly in future.
However, looking backwards to those LDI funds which were in place in October, there is an open question as to whether the LDI crisis could result in litigation against industry players such as the LDI platform providers and/or LDI investment consultants for compensation for any losses suffered by the scheme, for example due to a fire-sale of gilts at the bottom of the market to meet collateral calls. Arguably it would be more difficult to pursue execution only investment managers for any such losses.
We would see any such claims by scheme trustees focussing on: the way in which the risks in the LDI strategy were explained to pension schemes, particularly the risk of schemes having to post margin if and when positions moved against schemes; how liquidity in the overall investment portfolio was managed to enable assets to be sold to meet margin calls in pressured situations; and potentially even the manner in which the LDI provider executed the strategy. Fundamentally, these will be derivative claims framed around the following types of causes of action: misrepresentation, breach of advisory duties that pension schemes may try to imply into their relationship with LDI providers, breach of investment mandate, and similar.
Any such claims would be highly fact specific and challenging given the complexity of the subject matter. However, this may well be an area of interest to the UK’s claimant law firms who have a track record in combining multiple compensation claims to save time, reduce legal costs and improve the chances of success. Watch this space.
While much of the focus has been on defined benefit pension schemes, it should also be remembered that defined contribution pension schemes may also have invested in LDI funds, particularly in respect of members nearing retirement age where the investment strategy may have been to align their pension pots with gilts. It feels like more of a long shot, but it is possible that DC members who have suffered losses may be persuaded to pursue the LDI providers, possibly as a collective action, off the back of any successful claims in the DB space.
Finally, perhaps an unintended consequence, but it seems to us that for some trustees and sponsors the headache caused by the LDI crisis may accelerate the scheme’s “endgame” by speeding up the full buyout of the scheme or entry into a superfund, to eliminate such funding risks for the trustee and sponsor going forward.