The Government Actuary’s Department (GAD) has called for increased visibility of the operational and governance risks associated with strategies such as liability-driven investment (LDI), following liquidity issues faced by defined benefit (DB) schemes in 2022.

In response to a request for insight from the Work and Pensions Committee, government actuary, Martin Clarke, said that the liquidity crisis was exacerbated by governance and operational bottlenecks within parts of the system, particularly in relation to pooled funds.

In particular, Clarke highlighted two main contributing factors, the first of which was the large aggregate volume of assets that were aligned to the same strategy, with an estimated 1,800 separate pension schemes using pooled LDI funds, of which some were employing high levels of leverage.

Alongside this, Clarke identified issues around the inadequacy of collateral plans to prove resilient in the face of such large market movements, explaining that there were significant governance challenges that had to be overcome to effect the required collateral postings.

In light of these issues, Clarke suggested that one lesson to be learnt from the experience is to increase the visibility to all stakeholders of the operational and governance risks associated with strategies such as leveraged LDI, and especially those associated with pooled funds.

Clarke stated: "The Pensions Regulator (TPR) has the power to collect data from schemes for regulatory purposes and can therefore obtain good aggregate and specific data on the use of critical investment strategies such as leveraged LDI.

"A more systematic, regular and comprehensive collection of data on such strategies and the collateral and operational risk management approaches adopted by schemes of all sizes may now be considered appropriate.

"Having such information to assess the scale and range of exposure, assists in engaging across the regulatory space to form mitigation strategies. Consideration may also be given to requiring schemes to perform and report on the results of investment stress tests."

More generally, Clarke suggested that consideration may also be given to the sufficiency of disclosure requirements on trustees about their governance and management of investment and associated operational risks.

In addition to this, Clarke suggested that improved availability of data on LDI could help trustees appropriately challenge their advisers and LDI managers and to make judgements on the potential benefits of using LDI relative to the complexity and risks it can introduce.

However, Clarke warned that there should be “some caution against an over-reaction or the introduction of overly restrictive regulations”, clarifying that many schemes that use LDI did weather the issue as they were well prepared.

He continued: “A number of mitigations have already been voluntarily introduced from various stakeholders and the wide coverage of this issue is expected to have provoked users of LDI to challenge their investment strategies and governance processes.

“It is worth noting that in general, leveraged LDI allows schemes to manage funding risks from changing bond yields, whilst still having funds available to invest in non-bond assets, such as equities, that are expected to generate a higher return than bonds."

Clarke therefore predicted that LDI will “will continue to have an important role for schemes on this journey, potentially right up until the purchase of bulk annuities”.

Share Story: