Protecting against LDI ‘systemic risk’ requires “better data” on pension scheme funding and investments

LCP partner Jonathan Camfield has today given oral evidence to the Work and Pensions Committee as part of the Committee’s inquiry into “Defined Benefit pensions with Liability Driven Investments”. This builds on his written submission to the Committee which LCP are publishing today.

In addition to the problems faced by individual pension schemes following the 23rd September ‘mini-Budget’, the Bank of England had to step in to deal with ‘systemic’ risk, as forced sales of Gilts led to a downward spiral in Gilt values. In response, regulators such as the Bank of England have put the blame in part on ‘poorly managed leverage’ and a failure to take account of ‘systemic risk’.

However, according to Jonathan Camfield’s evidence, regulators did not collect and report on detailed system-wide data which could have informed judgments by individual schemes on systemic risk.

Jonathan Camfield points out that in 2018 the Bank of England undertook a study[1] into the risks of leverage in the “non-bank” financial system, which is primarily leveraged LDI in pension schemes. At the time, the Bank concluded that:

“Data currently reported to the supervisors [ie TPR] of non-banks [ie pension schemes] do not include all the information needed to monitor the risks appropriately. The Bank will work with other domestic supervisors ….— to enhance the monitoring of these risks”.

The Bank went on to conclude that

“If it is found that risks reach systemic levels, further action should be considered”.

However, whilst it is clear that the FCA has been talking to the main LDI managers and collecting partial data over the course of 2022 to-date[2], TPR has confirmed that “We do not record in-depth data on the scale of collateral or leverage agreed to by DB schemes, and we do not ask every scheme to provide this data.”[3] It is this systematic full data, from all schemes, rather than the narrower view of investment managers, that would have enabled a full picture of the systemic risks being taken. It also appears that, up until 23 September at least, regulators including the Bank had not concluded that risks had reached ‘systemic levels’.

As Jonathan Camfield points out in his analysis, if regulators do not obtain data about the system as a whole, and do not find that there are systemic risks warranting further regulatory action, it will continue to be challenging for schemes to meaningfully assess systemic risks and reflect such risks in their risk management processes.

Going forward, the paper argues that we do now need systematic data, whether collected by TPR, FCA, the Bank of England or a combination of all three, in order to ensure that the regulatory regime is fit for purpose and that schemes can assess if they are taking appropriate amounts of risks. In particular, any new rules about the use of LDI, should be informed by an up-to-date and data-driven understanding of the current use of such strategies, and an assessment of the costs and benefits to individual schemes and the system as a whole of the continued use of a modified form of LDI strategy, carefully considering the risk of unintended consequences.

Commenting, Jonathan Camfield said:

“It is clear that in 2018 the Bank of England felt that the level of risk being taken collectively by pension schemes as part of their investment strategies needed further investigation. But it is not clear that the necessary data needed to assess any potential ‘systemic’ risk was collected, analysed and reported on. Whilst the majority of schemes and advisors were very much aware of their own individual scheme risks associated with LDI strategies, it is hard to see how individual pension schemes could have meaningfully allowed for additional ‘systemic’ risk when forming their own investment strategy. Going forward, better data and analysis is needed from regulators in order to inform future regulation and to make sure that any modified LDI strategies work not only for individual pension schemes but for the system as a whole”.

[1] See: Bank of England Financial Stability Report November 2018: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2018/november-2018.pdf

[2] See: FCA’s 20 October 2022 letter to the House of Lords’ Industry and Regulators and Economic Affairs Committees

[3] See: TPR’s 10 October 2022 letter to the Work and Pensions Committee