The LDI Crisis: Lessons for DB Pension Scheme Trustees

September 2022’s mini-Budget in the UK sparked unprecedented investment turmoil for defined benefit (DB) pension scheme trustees. Sky-rocketing gilt yields caused chaos in liability-driven investment (LDI) strategies, with knock-on effects for pension scheme governance, investment strategy, long-term planning, and the future design of liability-driven investment strategies.

Now that the dust has started to settle, DB pension trustees will be left with a lengthy to-do list to help them absorb the lessons, recover from the financial shocks inflicted over the last few months, and make future plans for their schemes.

Pensions governance

The volatility of the mini-Budget shone a light on investment governance practices and the burden that many trustee boards face when it comes to decision-making in a crisis. With a little more breathing space, trustees can now reflect on their governance framework and whether it is fit for purpose.

Questions to ask:

• Do we have the correct investment governance structure, decision-making frameworks and support in place to respond to any future crises?
• Could using a fiduciary manager or appointing a professional trustee have helped us?
• Are the delegated arrangements we have in place still appropriate?
• For schemes using a fiduciary manager: how did the FM perform through the crisis?
• Was the FM transparent about the approach it took, and were the outcomes as we expected?
• Should we review the FM’s terms, reporting and governance processes, or even carry out a reselection exercise?
• Did the flow, speed, and clarity of information received enable swift decision making?
• Should we be updating our members and providing reassurance against the attention-grabbing headlines?

Investment strategy

Forced selling of liquid assets, such as equities, to meet collateral calls meant that some schemes’ investment strategies have skewed away from their strategic targets. That may have left the scheme with an overdependence on illiquid assets, for example, or with insufficient growth assets in the portfolio.

Questions to ask:

• Do we need to reposition our portfolio over time to meet our long-term target?
• Should we reconsider our investment strategy in the light of progress towards an end goal such as buyout?
• How far has our current strategy deviated from our agreed allocation?
• Has the crisis introduced risks elsewhere in our scheme – for example, do we need to rebuild cash holdings to ensure we can meet any future cash flow issues and continue to pay pensions?
• How overweight is our allocation to illiquids? Are there opportunities on the secondary market?
• Is the strategy robust for future potential shocks to liquidity and yield movements?

Long-term planning

Market movements affected many DB pension schemes’ funding positions, potentially accelerating progress towards an end goal such as buyout. Although gilt yields have now fallen from their high point in late 2022, they are still significantly higher than 12 months ago.

Questions to ask:

• Could we lock in any improvements to our funding position?
• Can we consider any additional de-risking activities?
• Should we be repositioning any de-risking triggers?
• If full buyout is now a realistic prospect, are other aspects of preparation such as preparing a benefits specification underway so that we can act quickly in future?
• And if we are considering buyout, is our portfolio liquid enough to support that goal?

Future use of LDI strategies

LDI strategies are still a valid strategy for many pension schemes and are an effective way to hedge a lot of the risks associated with a pension scheme. However, it is true that they are no longer the ‘poster child’ for investment strategies that they once were. Regulators, the Bank of England, and LDI providers themselves are all looking to take action to make LDI strategies more resilient and reduce future systemic risk. For example, the Bank of England is already debating what a ‘steady state’ framework would look like to address risk, particularly in pooled liability-driven investment funds. And it is still possible that the industry may see more regulation introduced as a result of political pressure.

Questions to ask:

• Are our LDI fund managers planning to make changes to the way their funds operate?
• If so, how will this affect our wider investment strategy – for example, will LDI managers require us to hold greater liquidity buffers with them, potentially restricting the opportunity set we could invest in and is this approach right for our scheme?
• Do we want to review our hedging strategy, especially if we are now closer to buyout?
• Are we aware of the latest developments in regulation and LDI fund design, and understand how these will affect our scheme?
• With leverage levels reduced, are LDI strategies as effective to hedge our risks? Are alternatives just as appropriate?

The events of 2022 will live long in the minds of everyone involved with DB pensions investment. That said, many DB schemes are in a better funded position now and recent events are an opportunity for trustee boards to assess and improve how they make investment decisions in a crisis.

How ZEDRA can help

Professional trustees can help by supporting boards in making governance changes, acting as the conduit between advisers and other trustees, and strengthening trustee decision-making for the long term.

To find out how our team can assist your pension scheme, please contact Alan Greenlees.