The Pensions Minister, Laura Trott, has responded to the Work and Pensions Committee’s (WPC) recent queries around liability-driven investment (LDI) in defined benefit (DB) schemes, as concerns over the legality of some aspects of LDI continue.

The WPC previously wrote to Trott around some of the recent issues raised as part of the committee's inquiry, after industry evidence suggested that “use of derivatives to hedge liabilities is also almost certainly illegal", based on the UK's transposition of the European directive.

In response, Trott confirmed that the transposition made reference to risks in general, rather than a specific reference to investment risk, explaining that “this effectively made it possible for trustees to consider a wider set of risks and circumstances in their use of derivatives than those shown on the face of the IORP Directive”.

She continued: “This change will have been made in response to the feedback on the government’s consultation on The Occupational Pension Schemes (Investment) Regulations 2005 in which the department explicitly set out that we wanted to allow derivatives and repos.

“Our subsequent approach was based on feedback from industry in which they expressed concern that gilt repurchase schemes and various other types of legitimate investment may be inadvertently restricted."

In addition to this, Trott confirmed that, as is standard practice when producing legislation, the Department for Work and Pensions (DWP) took “suitable legal advice” at the time and throughout the implementation process.

TPR has also recently written to the Industry and Regulators committee to provide further clarification on its standing around these issues, confirming that it considers borrowing as defined in the regulations to be different to the use of derivatives.

“When pension funds use leveraged LDI, they typically use swaps or ‘repos’ or a combination of both,” the regulator explained.

“These derivative instruments are used in both pooled fund and segregated arrangements and allow pension funds to benefit from exposure to long dated cash-flow payments. A closer match with future pension cash-flows (liabilities) reduces the mismatch in assets and liabilities, and thus reduces funding risk.

“Regulation 4(8) of the 2005 investment regulations explicitly allows trustees to use derivative instruments.

"They may be used where they contribute to a reduction in risk or facilitate efficient portfolio management (including the reduction of cost or the generation of additional capital or income with an acceptable level of risk). In principle, use of derivatives in LDI funds is consistent with this provision.”

Furthermore, in relation to the contention that repos are not borrowing, TPR stated: “We are confident of our interpretation of regulation 5 of the 2008 investment regulations, informed by the analysis of our experienced in-house legal team.

“As such, we have not considered it to be something on which we needed to instruct counsel. The pensions legal profession, as a whole, has also not considered it to be a matter of significant debate.”

TPR was responding to concerns raised by Baroness Bowles in a recent Industry and Regulators committee hearing, with Bowles arguing that “there is no doubt that, economically, [leveraged LDIs] are borrowing”, and that “repo is not a derivative”.

Bowles has since also written to WPC chair, Stephen Timms, highlighting a number of specific changes to the transposition, which she argued were “pertinent to the use of borrowing, leverage, derivatives and the nature of permitted risks”.

She stated: “It is clearly laid out that redrafting away from the wording of the directive was deliberately done to bring inside the transposition various investment strategies that the directive excluded and the term ‘reduction in investment risk’ effectively swapped to increased (acceptable) investment risk.

“In my view the changes to restrictions and reversal of meaning depart from the result required by the directive. Given the UK courts’ duty, there is risk that these adjustments to the wording of the directive are of no effect and would be ignored.

In addition to this, Bowles noted that as pensions were not technically under financial services, they were left out of the financial stability revisions, noting that this is "a situation that still pertains today".

Share Story: