The summer of 2022 was a precarious time. The market had started to see some increases in gilt yields, but the increased volatility in the gilt market following the September 2022 mini-budget resulted in unprecedented increases in gilt yields in a very short space of time. Given the highly leveraged LDI instruments held by many schemes, there were significant calls for collateral which, in many cases, needed to come from other assets held by a scheme. The extent to which these assets were liquid was crucial as these calls for collateral were time critical.

LDI was the investment of choice for many pension schemes wanting to remove investment-related risks. There is a herd mentality within the UK pensions industry, supported by the Regulator’s messages on the need to control risk when considering a scheme’s funding and investment strategy. The LDI crisis was very much a UK systemic event as a result.

Generally (but not in all cases), trustees reacted quickly, and investment consultants worked round the clock to ensure the trustees had the information to be able to make swift decisions to meet the collateral requirements. The whole debacle, however, shone an illuminating light on the governance processes surrounding the rapid need for liquid assets. Were the signatory lists up to date? Was there an automated process pre-agreed for such scenarios? If not, was the Trustee Board able to convene at short notice to make the required decisions? Did the pension scheme have the required level of liquidity? In more than a few cases, the answer to these questions was no. This resulted in last-minute damage limitation and some adverse impacts on funding levels.

How has the approach to LDI changed?

The events of last Autumn have fundamentally changed the way schemes navigate their responsibilities. There has been a massive learning curve within the industry to ensure that such investments are used in the right way. Collateral buffer levels have been raised to provide increased levels of resilience to future market movements. This has meant that the level of leverage has decreased significantly and some hard decisions have been made as to whether to maintain the level of hedging held before the ‘crisis’ which would now be more costly. And take more risk elsewhere to obtain the required level of return or reduce the level of hedging accepting the increased level of exposure to interest rate and inflation movements. Education has been key, from the investment managers and consultants to the trustees and the regulatory bodies. There is greater emphasis now on trustees being encouraged to ask the challenging questions of their advisers to ensure that they truly understand the inner workings of these, frankly, complex investments and their associated risks.

Whilst there has been greater restrictions on how LDI portfolios can be used, there has not been a wholesale move away from such investments. Trustees still have confidence in LDI strategies and still see the value in including such risk-reducing measures into a well-diversified portfolio.

What has happened is a cold, hard look at ensuring that, should the events of 2022 be repeated, schemes are prepared. If rates rise, what could be sold quickly? Which investments should be sold and in what order? Who needs to be involved? What steps need to be taken in various scenarios and what can be automated? Many trustee boards have put in place emergency powers protocols should such an event happen again to help make nimble decisions and act quickly. Measures such as a temporary reduced quorum should the whole trustee board not be available to take the required action swiftly.

It is surprising how the pensions industry continues to use archaic practices – a requirement for wet ink signatures continues to be a feature. Many trustees have engaged with their investment managers to put in place more efficient practices for the future such as the greater application of technology to request signatories. This does not come without its problems. Technology can be blocked by company firewalls and signatures need to be in a prescribed format. Which makes it all the more important to iron out the issues ahead of any future crisis event occurring.

There is increased scrutiny from regulatory bodies on the use of LDI instruments as part of a scheme’s investment portfolio. And this has led trustees to think more widely about their investment governance practices. In particular:

Client service: This was a key component of the investment management services at the height of the LDI crisis, particularly communication, and so prompted many trustee boards to reflect on both the LDI manager’s performance and the support provided by the investment consultant. Whilst many performed well in the tough times, some unfortunately did not fare well and so we have seen a move to review investment managers and advisers.

Outsourcing: Some trustee boards are going one step further, wishing to reduce their governance burden through outsourcing to fiduciary managers or OCIOs. Having ‘experts’ in place to manage the investments of a scheme would also help in meeting the requirements of the General Code once it is published.

Trustee Knowledge and Understanding: The LDI events of 2022 could also be a factor in the argument to appoint an independent trustee on a board, particularly an individual with investment expertise. However, this does not negate the requirement for the whole trustee board to ensure that it understands how their investments are constructed. With the call, as part of the Mansion House Reforms, for pension schemes to be encouraged to invest in a more diverse range of assets, trustee boards who choose to go down this route will need to undergo sufficient due diligence and training to satisfy themselves that they understand the risks associated with such a decision and understand the controls to put in place should the worst happen. Trustees should not be afraid to challenge their advisers and ask the difficult questions.

Applying these lessons to a wider scheme governance context

There is a tendency within the pensions industry to be reactive rather than proactive. There have been some effective measures put in place by both the industry and individual trustee boards to ensure this scenario, should it be repeated, can be dealt with. But this is after the event.

We are good at analysing what has happened. And to a certain extent, through effective risk management practices, we can put in place controls and measures to help mitigate those risks that are keeping us awake at night. But what about those 1 in 20 events where the likelihood is low but the impact could be significant? Climate events come to mind, as well as the recent cyber attacks. The LDI event of 2022 was more like a 1 in 300 year event. However, some trustees had scenario planned such an event. A significant concern about these 1 in 20 events is that the chances are such an event could impact much of the UK pensions industry, such is the systemic nature of the system. We need to ensure that these systemic risks are included on a scheme’s risk register and taken seriously, however unlikely the scenario may be.

It is also worth highlighting the interdependencies between risks. In the case of the LDI crisis, interest rate and inflation risks were managed through the implementation of an LDI portfolio but as a result, there was greater pressure applied to collateral and liquidity risk.

A well governed scheme, despite its busy agenda, will acknowledge the benefits of scenario planning. Understanding what could go wrong and the implications is half the battle. Putting in place measures covering the ‘what if’ scenarios, no matter how unlikely, could save a lot of time and cost. Whilst such exercises are unlikely to replicate what might happen exactly, it does help trustees get into the right mindset so that they know the steps they need to be taking should a risk event materialise.

The chances are the next significant risk event is inevitably going to be systemic again. We should all be ready.