Long read: Industry experts divided as WPC LDI inquiry continues

Industry experts have suggested that trustee knowledge was a key issue during the recent liquidity issues faced by defined benefit (DB) pension schemes, as inquiries continue following the gilt market volatility.

The Work and Pensions Committee's (WPC) inquiry into liability-driven investment (LDI) and DB pensions continued this week, with MPs reassured that work is already underway to build resilience, although experts remain divided on the root cause of the recent issues.

Speaking at the WPC's latest evidence hearing, Dalriada Trustees director David Fogarty, argued that the primary problem was not leverage.

Instead, Fogarty suggested that the cause was a “combination of things”, including trustee board understanding as to what certain products are, the extent of leverage and what would happen if certain events happened.

In addition to this, he argued that there was a “series of operational failures”, explaining that even if a well-advised trustee board was in place that understood the situation, failed operational procedures, either between the trustee’s obtaining advice or between the asset managers being able to act upon the decisions that the trustees want to take, created "real problems within the system”.

Despite this, Fogarty also emphasised that the “buck has to stop with the trustees”, arguing that while “you can challenge whether the advice is good, bad or indifferent”, it is up to trustees to ensure that they get good advice.

Putting support in place

In addition to this, Fogarty argued that while The Pensions Regulator (TPR) has met its statutory duty, “there is a reasonably strong argument for trustees to be regulated, to lift the bar in terms of the capability and understanding”, querying whether there is currently a full understanding of the guidance being issued by TPR.

However, Barnett Waddingham partner and head of investment consulting, Rod Goodyer, warned that “not everybody can be brought up to the same level of understanding” on such complex issues, also stressing the need to maintain a diversity of thought.

“You'll have a diversity of skills across the trustee board in a whole range of areas, one of them might have legal skills, some of them might have finance skills, and you don't want to lose that diversity of thought within trustee boards," he continued.

“There probably is also a challenge that not everybody can be brought up to the same level of understanding on the most complex issues facing pension trustees, of which investment is only one.”

Adding to this, Association of Professional Pension Trustees chair, Harus Rai, agreed that “there are clearly lessons to be learned from this”, pointing out that the regulator themselves have said there is a need to gather more data around LDI holdings.

“This where we as an industry, as trustees and advisors, need to come together and work with the regulator," he continued, "because it's not just a regulator where there's lessons to be learnt".

Getting to the root cause

The panel were also asked for views on the concerns around hidden leverage previously raised as part of WPC's inquiry, with Goodyer arguing that it might not be correct to say that the leverage has been hidden, as is in the public domain in many cases.

“You can look for almost all pension schemes, and their statement of investment principles is available online," he stated.

“I think what would be a fair criticism is that sometimes the leverage is not easy to understand if you're not a pension professional, but I don't think it is correct to say that the leverage has been hidden. It is in the public domain.”

This was echoed by Rai, who stressed that, in addition to the statement of investment principles, trustees have an accounting requirement within their annual trustee report and accounts, which have to include risk analysis, who fund managers are, and market commentary.

The WPC also asked experts about previous comments from the Bank of England that suggested the recent issues were due to poorly managed leverage.

However, Insight Investment CEO, Abdallah Nauphal, said that he “only partially” agreed with this view.

“I don't agree that that was the primary cause,” he clarified, arguing that the issue “was a confluence of factors that came together that created this very unique event”.

“We need to recognise how jittery the markets were with regard to the long-term outlook for the fiscal position of the UK, at a time when the Bank of England was ready to start unwinding quantitative easing (QE),” he stated, explaining that the market turned from “jittery to panic” based on rumours and the subsequent confirmation of the mini-Budget.

He continued: “The second issue in our opinion, which was substantially relevant in here, was how illiquid or dysfunctional the gilt market became, especially the index-linked market.

“This is not a typical market you expect of a large government bond market. It was impossible to actually trade without seriously moving the market.”

Cardano Investment chief executive, Kerrin Rosenberg, also argued that “a complete lack of confidence” in the gilt market was a key cause of the issues, explaining that much like a run on the bank, there was “a run on the gilt market effectively for a few days”.

“There may well have been some pension funds who were less well able to manage themselves in those circumstances and it may be true that there was some poorly managed leverage amongst some," he acknowledged, clarifying however that these were "probably on the margin", with a small number of schemes disproportionately affected.

Adding to this, Investment Association director of policy, strategy and innovation, Jonathan Lipkin, flagged a distinction between why the markets were in that state of dysfunction, and what can be done to ensure operational resilience in future.

Building future protections

He continued: “We are in the early stages still of the regulator investigation… and what we are indicating very clearly equally clearly is that in such situations are there are operational lessons to learn and I think we would be aligned with some of what is being said by the bank and regulators about how we ensure maximum resilience going forward.”

Changes have already been made, however, as Lipkin suggested that “hindsight now will be baked into the data sets going forward”, confirming that stress have adjusted, and are being reflected in the greater collateral buffers that are emerging, which in turn implies lower leverage.

Adding to this, Rosenberg said that the question now is what sort of extreme event is it prudent for scheme to plan for, clarifying that while “with the benefit of hindsight, the buffer should have been larger”, that doesn't invalidate the tools or process already in place.

Rosenberg also emphasised the broader benefits of LDI, highlighting the case of one pension scheme that was worth around £1.3bn 15 years ago, explaining that without deploying leverage, this particular scheme would have been £600m worse off today, despite the yield rises experienced in 2022.

“I would say there's nothing unique about this pension fund, the analysis and the mechanics are exactly the same for any other,” he added, explaining that as leveraged LDI is protected against inflation and interest rates, it stabilised their funding ratio.

“Had they not used leveraged LDI they would have been paying out pensions, the asset base would have collapsed and, at some point, it almost certainly would have had to go into the Pension Protection Fund (PPF)."

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