TPR has published updated guidance setting out practical steps trustees can take to manage risks when using leveraged LDI.
Overview
TPR acknowledges that LDI is useful for reducing the risk to a scheme’s funding level from falls in long-term interest rates and/or rises in the market’s inflation expectations. LDI can be leveraged or unleveraged; the use of leverage brings additional liquidity risks as collateral demands can arise at short notice when interest rates change.
Trustees should ensure that they have appropriate controls and governance in place to support their LDI, including processes for working with their advisers and managers, so that they can act quickly and effectively.
LDI is technical in nature, so trustees should ensure that their advisers have the appropriate knowledge and experience and put the right controls in place around their services. However, trustees should remember that they retain ultimate responsibility for their investments and so should acquire and maintain appropriate knowledge and understanding. In respect of LDI, trustees should be familiar with how it works and the associated risks of using it.
Investment strategy
Trustees should review their investment strategy on a regular basis and when there have been significant changes to their scheme’s circumstances or market conditions. Changes to the level of leverage available in LDI funds will impact the level of asset / liability matching trustees are able to achieve. Trustees should seek advice as appropriate and work with the sponsoring employer to ensure that the investment risks are compatible with the funding of the scheme.
The guidance lists the factors that trustees should consider when deciding where LDI fits into their investment strategy, including:
- the desired level of interest rate and inflation hedging,
- the appropriate level of liquid assets required to meet both benefit payments and potential collateral calls,
- the overall levels of expected risk and return on the asset portfolio and
- the collateral requirements of the LDI funds.
Collateral resilience
LDI arrangements maintain a “buffer”, comprising cash and other liquid assets, which can be drawn on by the fund manager if additional collateral is called for as a result of changing market conditions such as a rise in Gilt yields. A smaller buffer means schemes may be called upon more frequently to provide additional collateral to replenish the buffer. On the other hand, a larger buffer ties up more of a scheme’s assets in collateral, which tends to reduce a scheme’s expected investment returns.
The guidance sets out the considerations that should inform the trustees’ policy for how they will provide collateral. This may include pre-agreed instructions for funding calls, for instance from a single fund or from a list of funds in a particular order, and should consider also how the assets used for collateral should be topped up, especially in circumstances like Autumn 2022 when several cash calls came in quick succession.
TPR notes that trustees may also be able to rely on other sources of cash to replenish collateral, for example through a short-term line of credit with the sponsoring employer.
TPR recommends that trustees test the resilience of their LDI investments and processes on a regular basis, recording the outcome of the tests and addressing any issues that arise. The guidance describes two methods of testing:
- modelling how the investments, processes and ability to pay benefits in a timely manner are affected by a range of different scenarios and
- ascertaining the market movement required to trigger a collateral call and that required to exhaust the assets that are held to cover such calls.
Governance and monitoring
TPR expects trustees to understand how their investment governance model affects LDI implementation, being clear as to which party is responsible for certain activities such as:
- advising the trustees about the appropriate level of hedging,
- advising the trustees about which assets should be sold to meet collateral calls,
- monitoring the level of the collateral buffer and
- selling assets to meet collateral calls.
The guidance suggests also that trustees ask their LDI manager what steps they have taken to meet the good practice in LDI management set out by the Financial Conduct Authority and the guidance from the National Competent Authorities (the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier of Luxemburg) (NCAs).
TPR sets out a list of considerations for trustees in terms of the information they should require from their managers and advisers to enable them to monitor the effectiveness and resilience of their LDI investments. This is likely to include out-of-cycle information such as when the scheme’s buffer drops beneath a certain level or by a certain amount.