LDI crisis in September 2022 - What happened?
Many will know that the "mini-budget" of Friday 23 September 2022, led to an "LDI crisis" in the pensions industry and wider economy, but how did the crisis actually come about?
By way of background, "LDI" (liability-driven investing) products aim to help a DB pension scheme "match" its assets with its liabilities, and to invest in a way that focuses on the scheme's liabilities, rather than just the scheme's assets. The closest match for the risks associated with the value of the liabilities is long-term gilts, particularly those linked to inflation. The Pensions Regulator estimated late last year that about 60% of DB schemes have invested in LDI products in one form or another.
In a letter dated 5 October 2022, the Bank of England, when writing to the Chair of the House of Commons Treasury Committee succinctly explained how LDI strategies tend to work in DB pension schemes:
"LDI strategies enable DB pension funds to use leverage (i.e., to borrow) to increase their exposure to long-term gilts, while also holding riskier and higher-yielding assets such as equities in order to boost their returns. The LDI funds maintain a cushion between the value of their assets and liabilities, intended to absorb any losses on the gilts. If losses exceed this cushion, the DB pension fund investor is asked to provide additional funds to increase it, a process known as rebalancing. This can be a more difficult process for pooled LDI funds, in part because they manage investment from a large number of small and medium-sized DB pension funds".
This is how the September 2022 crisis came about - many pension schemes did not have sufficient liquid assets to meet their provider's (very urgent) collateral calls to increase the "cushion" referred to in the Bank of England letter. Many pension schemes struggled to find the required cash in such a short timescale (even highly liquid assets such as equities can take several days to sell) and this also meant that many had to sell gilts, thereby reducing their value further. As gilts prices fell, there was a risk of the entire cushion being eroded, leaving the LDI fund with zero net asset value and leading to a default on the borrowing, meaning the bank counterparty would take ownership of the gilts. Whilst the pensions industry had looked previously at what level of economic shock the LDI market could withstand, the Regulator has since commented that the mini-budget caused an "extraordinary shock", which was much broader than anything the Regulator had expected or thought plausible.
During this period of extreme instability, we were advising various trustee and employer clients in relation to possible ways to manage and meet their LDI collateral obligations, with one key tool emerging as short-term loans provided by employers directly to their pension scheme trustees.
The Bank of England was forced to intervene to stabilise the gilts market on 28 September 2022 and this led to a return to more normal trading in the LDI markets (gilt yields fell by more than 10% on the day of the intervention). However, many lessons have been learnt and trustees, the Government and the pensions industry more generally are continuing to digest what happened and to consider longer-term changes to avoid a repeat of what took place in September last year.
Government and pensions industry responses to the LDI crisis
(i) The Pensions Regulator
The Pensions Regulator published a statement on 12 October 2022, setting out the main issues it expected trustees to consider in managing investment and liquidity risks in the face of difficult market conditions and how to respond to the LDI crisis. Trustees were urged to engage with their investment advisers to understand their investment position and to decide if any changes should be made, for example, reducing their hedging position. The Regulator noted that it was important that "lessons [be] learned from these recent events". The Regulator recommended that trustees also review their operational processes to obtain liquidity at short notice, consider their liquidity positions generally (including considering employer loan arrangements) and to look again at the scheme's wider funding and risk position.
The Regulator issued a further statement on 30 November, noting, in particular, that "if a scheme is not able to hold sufficient liquidity, or is unwilling to commit to that level of liquidity, they should consider their level of hedging with their advisers to ensure they have the right balance of funding, hedging and liquidity." Further guidance was given to trustees to demonstrate robustness around liquidity buffers. It set out 10 steps for trustees to ensure they are able to react quickly in response to stress in the market, which included steps to stress-test their leveraged LDI fund assets and to specify how any assets would be sold and when the relevant cash proceeds would be settled. Where schemes can establish a line of credit with their sponsoring employer, the Regulator noted that such arrangements should be documented carefully and reviewed to ensure they are appropriate.
The Regulator has also been in written correspondence with the House of Commons' Work and Pensions Committee since last year, in particular to respond to the Committee's questions relating to the Bank of England's recommendations in December 2022 (see further below). The Regulator has given assurances around how it will regulate to ensure LDI levels are resilient, and noted that it is in correspondence with the DWP about introducing a new notifiable event in relation to the status of a scheme's LDI arrangements. It also touched on appropriate potential data collection measures and referred to the new industry-wide LDI buffer levels which have been introduced to avoid a repeat of the events of last year.
The Regulator has said that it will issue a further update in April 2023 (in its Annual Funding Statement) setting out longer-term expectations on scheme liquidity requirements.
(ii) The Bank of England
The Bank of England reported in December 2022 on the resilience of LDI funds, commenting that: "..this episode demonstrated that levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient, and that buffers were too low and less usable in practice than expected". It provided various recommendations for regulatory action to be taken in the LDI market. It noted the importance of DB pension schemes improving their liquidity management practices, and that appropriate reporting and data collection is likely to be needed to monitor the resilience of LDI funds. The Bank said that it would continue to work closely with domestic and international regulators "so that LDI vulnerabilities are monitored and tackled".
(iii) Government and Parliament
In November 2022, the House of Lords' Industry and Regulators Committee held two "non-inquiry" sessions, one with the FCA and the Regulator and the other one with a large provider in the LDI market. These were effectively evidence-gathering meetings, and each of the involved industry parties provided substantial background and detail on what happened in the LDI market in September 2022 and in the months beforehand.
Earlier in February 2023, the same committee wrote to two Government ministers setting out a number of concerns that it had in relation to the LDI market and providing recommendations for action to improve regulation and to reduce the risk of similar disruption in the future. Very broadly, the Committee has recommended:
- A review of accounting systems for pension schemes.
- A review of the Investment Regulations to tighten the use of derivatives and leverage by DB schemes.
- That investment consultants be brought under FCA regulation.
- To consider giving the PRA a role in overseeing DB schemes.
- To give the Regulator a statutory/ministerial direction to consider the impact of pensions on the wider financial system - also to give the Financial Policy committee power to take action by regulators in the pensions sector if they fail to take action to address risks.
The Committee has asked for a written response by 7 March.
The House of Commons' Work and Pensions Committee is currently carrying out an inquiry into the LDI crisis and has specifically asked for comments on the Regulator's draft funding code (the Committee had previously asked the Regulator to delay its current consultation as a result of this issue, but the Regulator declined this request).
Whilst it appears that LDI products are continuing to stabilise, it is also clear that lower levels of leverage in LDI offerings are likely to remain. The Regulator recognises the need for more effective regulation of LDI products and the House of Lords' recent recommendations to Government and the upcoming review by the House of Commons' Committee for Work and Pensions are both likely to lead to wider changes to the current statutory and regulatory regime.
In the shorter term, we can expect further guidance and commentary from the Regulator in its next Annual Funding Statement and possibly even a re-formulation of the draft Funding Code in reaction to recent events. We can also expect in March a formal session in front of the Committee for Work in Pensions in relation to this issue.
Key takeaways and action points
It is clear that the ramifications from the 2022 LDI crisis are likely to continue to be felt in the pensions industry for some time, and it is not yet clear exactly how significantly pension schemes LDI arrangements, and the wider LDI industry more generally, will have to change to avoid LDI funds coming as close to defaulting as they did last year. Nevertheless, in the meantime, trustees should:
- Ensure that both their LDI arrangements and their wider governance processes (e.g., signatory arrangements) are fit for purpose and compliant with the Regulator's recommendations, in particular regarding the general level of hedging within the scheme's investment portfolio.
- Review their contractual arrangements with their LDI providers to understand the obligations under the legal documentation, for example regarding collateral calls, and if necessary renegotiate or exit the investment.
- Ensure that they have sufficient access to liquidity, if needed, to meet collateral calls, and if necessary engage with their sponsoring employer group to obtain a credit facility to cover future liquidity issues.
Please speak to your usual Baker McKenzie contact if you would like to discuss any of the matters mentioned in this alert.