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Using leveraged liability-driven investment

Published: 24 April 2023

In September and October 2022 the Bank of England had to intervene in the gilt market to restore market functioning when sharp and rapid rises in gilt yields led to widespread selling of gilts by pension schemes’ liability driven investment (LDI) arrangements.

Following these events several recommendations have been made to improve the resilience of LDI to market events. This guidance sets out further detail on practical steps trustees can take to manage risks when using leveraged LDI. Trustees are urged to work with their investment consultants, LDI managers and other advisers in considering and implementing this guidance.

This guidance follows the Financial Policy Committee's statement on 29 March 2023, and replaces our October 2022 LDI statement and our LDI guidance from November 2022.

LDI managers will need to have regard to guidance put out by the Financial Conduct Authority, and pooled LDI funds to that put out by the National Competent Authorities (the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier of Luxemburg).

Overview

As a trustee, you are ultimately responsible for how the assets in your scheme are invested. Your investments must be appropriate for your scheme. You must put in place the right governance and controls, and understand the risks you carry in your investment strategy.

Many defined benefit (DB) pension schemes use LDI to better match their assets to their liabilities. LDI can be leveraged or unleveraged. In leveraged LDI, you use financial instruments to increase your allocation in certain assets (such as gilts, index-linked gilts, and fixed income derivatives), and these financial instruments require you to provide collateral to counterparties as security. The use of leveraged LDI brings additional liquidity risks and requirements as these collateral demands can change over short periods when interest rates change.

This guidance is concerned with leveraged LDI, though some of the elements may apply to non-leveraged LDI and you may wish to apply these where relevant. Any further reference to LDI should be read as meaning leveraged LDI. This guidance should be read in conjunction with our general guidance on DB investment.

Any references to gilts in this guidance should be read to mean both conventional and index-linked gilts.

You must ensure that you have robust and effective operational processes in place to ensure the resilience of your pension scheme to market shocks and reduce the risks to your scheme to acceptable levels.

This guidance sets out specific issues to consider when investing in LDI, including:

  • where LDI fits within your investment strategy
  • setting, operating and maintaining a collateral buffer
  • testing for resilience
  • making sure you have the right governance in place
  • monitoring LDI

This guidance applies regardless of the type of investment you use for LDI — for example whether you invest alongside other schemes (in pooled funds) or separately (segregated LDI or in a ‘pooled fund of one’).

You must ensure that you have the right controls and governance around LDI. You need to be confident that, particularly in a crisis, you have in place ways of working with your advisers and managers, so you can act quickly and effectively. This is particularly true if you have high levels of leverage, meet infrequently as a trustee board or have more infrequent contact with advisers.

LDI is technical in nature and you will need input from your advisers and other professionals such as LDI managers to implement LDI. However, you are ultimately responsible for the investments you make. You should take steps to satisfy yourself that those advising or supporting you have the appropriate knowledge and experience to do so, and put the right controls in place around their services, in line with our guidance on the selection, appointment, management and replacement of suppliers.

You must acquire and maintain the required knowledge and understanding to oversee your scheme(s). This includes being aware of when you need to take investment advice and knowing which activities you can or must delegate to an investment manager. You can find out more in our guidance on DB investments. In respect of LDI, you should be familiar with how it works and associated risks when using it.

Investment strategy

Setting and reviewing your investment strategy

We provide general guidance on setting your investment strategy. You should review your investment strategy on a regular basis and when there have been significant changes to your scheme’s circumstances or market conditions. Improved LDI resilience standards will impact the level of asset / liability matching you are able to achieve. You should seek advice as appropriate and work with your sponsoring employer(s) to ensure that your investment risks are consistent with the funding of your scheme or other support you receive from the employer.

You should consider the benefits and risks of LDI within the wider context of your scheme. On the one hand, LDI can help you manage volatile funding deficits by better matching the assets to liabilities, and supporting your funding journey as you move towards buy-out or to a position where you are less reliant on employer deficit contributions. On the other hand, LDI requires you to maintain a certain level of liquidity to meet collateral calls, which may impact your ability to invest in illiquid assets. If you are unable or unwilling to hold sufficient liquidity, you should consider your level of hedging with your advisers to ensure you have the right balance of funding, hedging and liquidity.

When determining where LDI fits within your investment strategy you should consider the following:

  • Your liabilities, and the extent to which you want to mitigate impacts from movements in gilt yields on your liabilities (hedging).
  • Expected payments (including benefit payments) relative to expected income from investments or contributions, and your confidence in your ability to meet your payment obligations, even if LDI arrangements are put under stress.
  • The expected return on investments, and the types and levels of risk you are willing to tolerate to achieve that return.
  • The collateral and cash call requirements of LDI arrangements.
  • The availability and liquidity of assets or other arrangements that can be used to meet cash calls.
  • Your strategic asset allocation. You should consider which assets might increase the risks associated with using LDI, such as:
    • illiquid assets, which cannot be easily or quickly be sold or otherwise used to raise additional cash for use as collateral in LDI
    • other assets that are sensitive to market movements and may also result in collateral calls (either independently to LDI or at the same time), such as currency hedging

You should document any changes to your investment strategy and ensure that you have a record of:

  • expected returns and risks
  • the assets you are invested in
  • target levels of interest rate and inflation hedging
  • how you can provide collateral for LDI if needed and how long it would take you to do so
  • how your strategy meets our expected resilience standards

You may also need to revise your statement of investment principles, in which case prior consultation with your employer will be necessary.

Types of LDI

There are different types of LDI. They may vary in whether they are looking to hedge for changes in real or nominal interest rates, or in the composition of the funds (for example, some LDI funds include credit or equities as well as gilts). They may have different collateral requirements or restrictions on assets that can be used as collateral. Your investment advisers should explain the features of the arrangements you are looking to invest in.

You should ensure the LDI investments you make are in line with the desired investment strategy. Before investing, you must obtain and consider written investment advice. Investment advice should cover the suitability of the LDI arrangement in meeting your requirements, the benefits and risks of the investment, and the recommended operational processes to make the investment work.

Collateral resilience

Resilience standards

The LDI arrangements you invest in need to be resilient to short-term adverse changes in market conditions. To do this, cash, cash equivalents and assets are held as a ‘buffer’, which can be drawn on by the fund manager if additional collateral is called for as a result of changing market conditions. Only assets that can reliably be sourced or converted to eligible collateral in a timely manner should be held in the buffer.

As a trustee, you should make sure the arrangements you invest in operate an appropriate buffer, and that the right processes are in place for drawing on and replenishing the buffer.

There are two elements to consider in the buffer:

  1. Having sufficient liquidity to manage day-to-day volatility in the market (an operational buffer).
  2. Additional liquidity to provide resilience during severe market stress (a market stress buffer).

These elements are cumulative. If an arrangement’s operational buffer is set at 100 bps, and the market stress buffer at 250 bps, the total buffer the arrangement needs to operate is 350 bps.

In pooled funds, the buffer will be set by the fund manager. In segregated funds it will be set by the LDI manager and the trustees. In either case, you should satisfy yourself that the buffer provides sufficient resilience and is operable with your scheme’s governance arrangements.

Operational buffer

A smaller operational buffer means you may be called upon more frequently to provide additional capital to replenish the buffer. A larger operational buffer reduces the frequency at which this might happen, but ties up more of your assets in collateral, with associated implications for your scheme’s investment returns.

When assessing the appropriateness of the operational buffer, you should consider the following:

  • Volatility in the gilt market — a highly volatile environment might put a lot of pressure on low buffer arrangements.
  • How quickly and effectively assets can be accessed, sold or otherwise converted to cash to replenish the buffer. Slower, more complex processes might require a large buffer.
  • The cost of making asset sales to meet collateral demands or replenish the buffer. Frequent sales as a result of a small buffer would incur greater costs.

The operational buffer should at least reflect gilt yield volatility in normal market conditions.

Market stress buffer

The LDI arrangement should also operate a market stress buffer, so the fund can operate as business as usual even where there are sharp market movements. This buffer should be, at a minimum, 250 bps. This minimum level assumes you are able to provide additional cash or assets to replenish the buffer within five days. If it is likely to take you longer, a larger market stress buffer may be appropriate. A larger market stress buffer may also be appropriate in other circumstances, for example if the assets held within the buffer are more volatile than assets typically held in LDI arrangements. Similarly, if the composition of the LDI fund is intrinsically less volatile than a gilt related LDI fund, it may be acceptable to use a lower market stress buffer.

The 250 bps minimum resilience level should be maintained in normal times but can be drawn down on in periods of stress.

Maintaining the buffer

You may be called upon to provide additional cash or assets to replenish the buffer if it drops too low. You should understand the thresholds or conditions under which these ‘cash calls’ will take place, put in place processes for meeting these calls, and record these processes (for example in a collateral management policy).

You may want to specify which assets can be sold for raising cash in pre-agreed instructions to be shared with relevant parties. You might do the following:

  • Use a single fund to raise cash.
  • Use a pre-specified portfolio of assets to raise cash.
  • Use a waterfall of funds, ie using the first fund for cash until it is exhausted, followed by a second fund, third fund and so on.

You should assess and understand the risks associated with each of the above options in terms of your ability to meet cash calls quickly, and the complexity and costs associated with the sales process.

When determining which assets to use, you should consider the time it takes to sell these assets (including the time needed to make the decision, notice periods and settlement times). LDI managers will expect calls to be met within a certain timeframe (typically within five working days). You should speak to your managers about their timeframes (in normal times but also in times of stress) and make sure that the assets you use to meet cash calls will be able to be sold within those times. You should be mindful of how stressed market conditions may impact their liquidity and operational availability. You should also consider how the value of the assets is impacted by market movements — if the circumstances which lead to a cash call are also likely to lead to a reduction in value of the assets, they may be less suitable to use.

You may also be able to rely on other sources of cash to replenish collateral, for example through a short-term line of credit with your sponsoring employer(s) or repurchase agreements. Such arrangements should be documented and reviewed regularly to ensure they remain in place and clearly reference the time period, amounts and conditions. You should make sure any arrangement is reviewed legally to ensure the facility will be available when it is needed.

You should be clear on the process for selling the assets: who is authorised to sell them and under which circumstances, who the instructions to sell need to go to and by when, and whether electronic or wet ink signatures are required.

You may decide to retain decisions on cash calls. In this case, you will need to make quick decisions. You need to keep a list of authorised signatories, review this periodically and amend it as soon as possible if a trustee resigns or is appointed. You should make sure you have a sufficient number of signatories to cover absences.

Alternatively, you can delegate the selling of assets to meet cash calls to the LDI manager, an investment platform, or a fiduciary manager. All delegations should be clearly defined and recorded, and appropriately reflected in legal agreements and contracts. There can be a squeeze on resources in extreme market conditions. Therefore, you and your advisers should regularly review the operational processes and resourcing of these service providers, paying particular attention to the use of technology, which avoids the need for manual intervention.

You need to consider how your processes work in the event of cumulative cash calls, especially if these arrive in quick succession. You also need to consider how you intend to top up these assets if they are sold, to ensure a continued supply of liquid assets to top up the LDI arrangement as long as this remains appropriate for your scheme.

Resilience testing

You should test the resilience of your LDI investments and processes. Your investment adviser or LDI manager will design these tests, but you should be confident that they are sufficiently robust and provide you with the information you need to understand the risks. You should record the outcome of these tests, and address areas of concern.

These tests should be done regularly (for example on an annual or triennial basis, alongside wider investment strategy testing) but also when there are significant changes to your scheme’s funding or investment position, or significant changes in market conditions.

Testing for resilience can be done in one of two ways:

  1. Looking at how your LDI arrangements and processes perform under different scenarios that are relevant to your investment strategy and vulnerabilities. These should consider a range of circumstances, for example market movements of different sizes, speed and duration. The tests should take a holistic view of the impacts, looking at:
    • the impact on the LDI arrangement and collateral buffer
    • the impacts on the assets you have earmarked to replenish the buffer
    • the size of the cash call(s) that would need to be made, and any associated transaction costs
    • how quickly transactions would need to be made, and how well your operational processes and those of your advisers/providers would be able to meet this; considering how long it takes to receive information, make a decision, instruct and taking into account the dealing cycle of assets
    • the impact of dealing cycles, for example what happens if you have just missed the dealing cut-off point
    • the impact on other assets or derivative instruments (such as equity or foreign exchange) where relevant
    • if other schemes or parties are likely to be in the same position as you and looking to act at the same time (which could affect your ability to respond)
    • the impact on your overall investment portfolio
    • any risk to your ability to meet payment obligations such as benefit payments
  2. Determining the size of market movement required before a specific event would happen, for example when you would be called upon to replenish the buffer (the next cash calls) and how large a change is needed before you run out of the assets you have earmarked for replenishing the buffer.

Governance

Schemes operate different investment governance models. Some trustees only delegate day-to-day investment decisions to an investment manager, while others delegate a range of investment powers to a fiduciary manager. Other governance models include in-house management and Outsourced Chief Investment Officers.

You should understand how the investment governance model affects LDI implementation. You can seek advice on governance models and the relative merits from independent advisers and find more information in our guidance on DB investment and our guidance on investment service providers.

You may be supported in respect of LDI investments by investment advisers, investment or fiduciary managers and LDI managers. You should be clear on each party’s respective role and responsibilities in respect of LDI, for example:

  • who calculates the liability cash flows
  • who advises you about the extent to which you should be looking to hedge these
  • who advises you on which arrangements to invest in
  • who advises you on which assets are sold to meet cash calls
  • who monitors the level of the collateral buffer
  • who makes the sales when cash calls need to be met
  • which decisions or actions you are delegating

You must make sure that responsibilities and delegations are appropriate to the governance of your scheme, including the frequency of trustee meetings and engagement with advisers. When setting delegations, you should ensure you are not delegating key strategic decisions, which must remain with the trustee. You should receive information on how the delegated authority is being used to ensure it is consistent with what you’ve agreed.

You should set out clearly the service each party is providing, processes that must be followed, and any discretion or limitations, and ensure these services are appropriately reflected in legal agreements and contracts. You should seek assurance that all parties have the required capacity to operate in stressed market conditions, and that action can be taken promptly as required.

You may also want to ask your LDI manager what steps they have taken to meet the good practice in LDI management set out by the Financial Conduct Authority, and, in relation to any pooled funds you use, how they meet the guidance put out by the National Competent Authorities (the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier of Luxemburg) (NCAs).

You may also need to consider if other delegations remain appropriate. For example, fiduciary managers may have some freedom to increase allocations to illiquid assets based on the investment management agreement and the strategic (target) asset allocation set by trustees. You should review whether the potential allocation to illiquid investments remains appropriate and negotiate suitable constraints in investment management agreements if necessary.

You should periodically review the appropriateness of your governance arrangements and operational processes.

Monitoring

You should make sure there are processes in place for monitoring the resilience of your LDI arrangements, taking into account our guidance on monitoring scheme investments. You should understand what monitoring your advisers or the LDI managers perform routinely, and put in place mechanisms to ensure you receive necessary and sufficient information to understand, and be able to react to risks.

You should work with your advisers to determine which information will be reported to you and by whom, and ensure that LDI managers are able to provide you with this information in the time and to the level of quality you require. Given the technical nature of LDI and bond and derivatives markets, you are also likely to need adviser support.

You should consider how often you want to receive information and how quickly this will need to be provided, and balance frequency of monitoring against costs. If your trustee board meets infrequently, you may consider delegating the oversight of LDI to a subcommittee or an adviser.

Some examples of data that may be useful in monitoring LDI resilience are:

  • the value of LDI assets
  • the value of the assets available to meet cash calls
  • the value and liquidity of assets earmarked for cash calls
  • the size of the operational and market stress buffers and how these compare to recent and long-term market volatility
  • the size of market movement which needs to take place before the next collateral calls would need to be made, and how large these calls would be
  • if any collateral calls have been made — which assets were sold, the price achieved for these assets, and how the processes performed — for example the time taken to meet the cash call
  • whether hedging has been lost or reduced during the reporting period, and the impact of this
  • reminders of the timelines for meeting cash calls to LDI arrangements
  • reminders of the dealing cycles of assets identified to meet cash calls

The above data work alongside wider asset-liability metrics that trustees may already use, such as funding levels, Value at Risk, stress tests, hedge ratio analysis, and the performance of growth and matching assets.

In addition to regular reporting, you may want to ask for certain information to be provided outside the normal reporting cycle if certain triggers are met, for example when your buffer drops beneath a certain level or by a certain amount. In extreme market conditions you are likely to require information more frequently and promptly than under normal market conditions and you should work with your advisers to define these needs in advance.

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