Regulators must take a firmer grip on liability-driven investment (LDI) strategies according to the UK House of Lords report into the turmoil that swept through the gilt market and shook UK pensions schemes. Parliament’s Work and Pensions Committee has been told around £500bn ($605bn) in pension scheme assets are “missing somewhere” as a result of the crisis.

The report from the House of Lords industry and regulators committee also called for a rethink of the requirement for retirement income policies to be recognised in a company’s annual accounts. The committee, chaired by financier Lord Clive Hollick, takes the view that this requirement encouraged UK pension schemes to opt for LDI strategies that relied on borrowed money.

Control and oversight

“We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes,” said Hollick.

The report also calls for The Pensions Regulator to be given a statutory duty that enables it to consider the effect of actions in the pensions sector on the wider financial system, and for the Bank of England’s financial policy committee to issue directions to regulators in the event risks go unaddressed.

Before last September’s bungled budget triggered a 250-basis-point move in index-linked gilts in just five days, about £1.4trn ($1.9trn) was invested in LDI strategies used by about 60% of the UK’s 5,131 defined benefit pension schemes, according to the Financial Times. Those schemes covered almost 10 million people.

Legal status

The committee also called for “far stricter limits” in the level of leverage allowed as part of a regime of tighter control and supervision of LDI strategies. It also questioned the legal status of LDI strategies, and pointed out UK law prohibits pension schemes from borrowing to boost returns.

Regulation of investment advice to pensions schemes by consultants was also proposed, something that has already been suggested by the FCA.

It was reported this week that advisers XPS Pensions and Barnett Waddingham have cut ratings on some pooled LDI funds to the lowest level. BlackRock, one of the biggest players in the market, expressed disappointment at the move which it said was based on “a number of factual inaccuracies and misunderstandings”.

Trustee role questioned

The move came in the same week as a study of 147 senior lawyers by the London Solicitors Litigation Association revealed many were anticipating a wave of litigation directed at advisers who recommended LDI strategies and at asset managers who run them. One senior partner said that the fact that trustees should have known what they were doing could be used by advisers and fund managers as a defence. All of which suggests protracted legal wrangling.

Last November, we questioned whether there was a strong element of people being wise after the event in the fallout from the LDI crisis. Julian Richards, a pensions expert and partner at JMW Solicitors, thinks the approach to pensions investment needs a deeper rethink, and isn’t convinced that more regulation is the answer.

“Discussions at trustees’ meeting these days focus on ‘what will the Regulator say?’ rather than ‘will this achieve the best deal for members?’ We’re in the world of reckless prudence,” he says.

“By definition, the cost of funding pension benefits is incorrect at the point of calculation.”

Julian Richards, partner, JMW Solicitors

“Under constant pressure from The Pensions Regulator to journey plan, trustees focus too much on eliminating risk and on embracing investment opportunities that promise to eliminate volatility. Enter LDI. 

“The valuation of defined benefit pension schemes is fundamentally an exercise in sophisticated guesswork. Making assumptions on unknowable factors such as price inflation, interest rates, wage inflation, investment returns and mortality means that, by definition, the cost of funding pension benefits is incorrect at the point of calculation.

“The answer isn’t yet more regulation. It’s removing some of the ever-increasing pressure on trustees to eliminate risk. We used to see risk as a measure of the likelihood of good and bad outcomes from a course of action and make decisions accordingly. Now we see risk as something dangerous, to be avoided at all costs.

“Ease the regulatory burden on trustees, back off from the drive to manage schemes out of existence and allow for some increased risk in portfolios.”