The Pensions Regulator (TPR) has faced criticism for not focusing sufficiently on the risks that borrowing to boost investment returns could pose to pension scheme finances, and wider financial stability in the event of interest rates rising.

The comments were made by the Industry and Regulators Committee in a letter to Economic Secretary to the Treasury, Andrew Griffith, and Pensions Minister, Laura Trott, which critiqued the use of leveraged liability-driven investment (LDI) strategies by defined benefit (DB) pension schemes.

In particular, the committee argued that LDI strategies, particularly those using leverage, were created as a solution to an "artificial problem" created by accounting standards, which pushed sponsoring companies to focus heavily on current, rather than long-term, estimates of pension deficits.

It also reiterated concerns around the legality of some aspects of LDI, arguing that the use of borrowing and derivatives for these purposes is not permitted by the relevant underlying EU legislation, pointing out that this was "permissively transposed" in the UK to allow pension schemes to continue using such strategies.

In addition to this, the committee argued that 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.

Considering this, it suggested that some pension scheme trustees may have become dependent on advice from their investment consultants, noting that this advice to schemes is currently unregulated.

The committee also raised concerns around the regulatory response seen since, stating that despite calls for more information and a review of stress tests from the Financial Policy Committee, regulators appear to have been slow to recognise the systemic risks caused by the concentration of pension schemes’ ownership of assets such as index-linked gilts, and the increasing use of more complex, bank-like strategies and instruments by pension funds.

In light of these conclusions, the committee urged the government to take action to improve regulation and reduce the risk of similar disruption in the future.

In particular, it recommended that the government and the UK Endorsement Board review 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 committee also encouraged the government to review the relevant regulations and consider whether the use of repos and derivatives should be more tightly controlled and supervised in future, arguing that "far stricter limits and reporting on the amount of leverage allowed in LDI funds" is needed.

It also backed the Financial Conduct Authority's (FCA) recommendation for investment consultants to be brought within the regulatory perimeter, arguing that this should be done "as a matter of urgency".

However, it also emphasised the need for regulators to pay heed to the non-professional nature of trustees in their regulation of consultants and ensure consultants are liable for their advice.

It also recommended that the regulators should ensure they have more information on the leverage present within pension scheme finances and that stress tests are conducted.

Industry and Regulators Committee chair, Lord Hollick, stated: “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.”

Commenting in response to the committee’s letter, a spokesperson for 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 and overseas regulators, to monitor compliance with these minimum standards, and take coordinated 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.”

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