Seventh Report - Defined benefit pensions with Liability Driven Investments

The government's response

What the committee recommended 17

1. 1
   Accounting standards and funding requirements contributed to LDI and a shift in DB investments. Conclusion · paragraph 34
2. 2
   TPR's approach to regulating scheme funding served as a motivation for LDI strategies. Conclusion · paragraph 41
3. 3
   UK transposition of IORP allowed leveraged LDI, introducing risks evident in September 2022. Conclusion · paragraph 46
4. 4
   Prevent DB pension scheme investments from jeopardising the UK economy in future. Conclusion · paragraph 54
5. 5
   Concerns raised about the reliability of reported pension scheme funding level improvements. Conclusion

See all 17 recommendations and conclusions

Sources

• Seventh Report - Defined benefit pensions with Liability Driven Investments ↗The committee's report, HC 826, parliament.uk
• First Special Report - Defined benefit pensions with Liability Driven Investments: Government Response to Committee’s Seventh Report of Session 2022–23 ↗The government's response, 20 November 2023, parliament.uk

Recommendations and conclusions 17

1. 1
   Accounting standards and funding requirements contributed to LDI and a shift in DB investments. Conclusion · paragraph 34 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   Both accounting standards and pension scheme funding requirements contributed to the development of LDI. The requirement to calculate a present value of liabilities using a market-based discount rate resulted in liability levels being very sensitive to changes in interest rates. LDI was an attempt to manage the resulting volatility in funding levels. While this may be appropriate for mature schemes, it is not obviously so for open schemes, for example. One outcome has been a shift in DB scheme investments from equities to bonds—reducing an important source of capital for the UK economy. This must have contributed to recent difficulties in securing investment and growth in the economy. Whether more flexibility could be allowed in the calculation of liabilities is a complex issue to which we will return in our wider inquiry on DB pension schemes.
2. 2
   TPR's approach to regulating scheme funding served as a motivation for LDI strategies. Conclusion · paragraph 41 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   A second motivation for LDI has been The Pensions Regulator’s approach to regulating scheme funding in line with its statutory objectives to protect member benefits and the Pension Protection Fund. We will return to the question of what is needed for open DB schemes to thrive in our inquiry on DB schemes.
3. 3
   UK transposition of IORP allowed leveraged LDI, introducing risks evident in September 2022. Conclusion · paragraph 46 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   The European Directive on the Institute for Occupational Retirement Provision (IORP) contained restrictions on borrowing. In 2005, the UK Government took the decision to transpose it into law in a way that allowed existing investment practices, including the use of derivatives and gilt repo, to continue. Supporters of leveraged LDI argue that it helped improve scheme funding levels. However, it introduced new risks, making pension funding levels very sensitive to changes in gilt yields. These risks needed to be understood, with adequate arrangements in place throughout the investment chain to manage them. Deficiencies in this became evident in the LDI episode in September 2022.
4. 4
   Prevent DB pension scheme investments from jeopardising the UK economy in future. Conclusion · paragraph 54 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   Sharp rises in gilt yields which LDI funds lacked the resilience to manage, led to the Bank of England having to intervene in September 2022 to protect financial stability. DB pension scheme investments must not be allowed to jeopardise the UK economy again.
5. 5
   Concerns raised about the reliability of reported pension scheme funding level improvements. Conclusion · addressed to Department for Work and Pensions Conclusion (the committee's words)

   According to TPR the majority of pension schemes emerged from 2022 with improved funding levels. However, external analysis raises questions as to how confident we can be about these improvements. We are concerned that some schemes had their funding levels negatively affected as a result of the events of September
6. 6
   FPC guidance protecting financial stability welcomed, awaiting Bank of England stress test results. Conclusion · paragraph 72 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   The objective of the latest Financial Policy Committee (FPC) guidance, to protect financial stability is welcome. We look forward to seeing the results of the Bank of England’s planned stress tests, made more pressing by recent rises in gilt yields.
7. 7
   Require TPR to mandate trustee data reporting on LDI and develop engagement strategy. Conclusion · paragraph 81 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   Leverage may have worked relatively well for pension schemes during a long period of low and volatile interest rates. However, it exposed them to additional liquidity risk and requirements, as collateral demands can change over short periods when interest rates change. With the imposition of much higher capital buffers, the cost of LDI has risen. For schemes in deficit who use these strategies, this may mean it takes longer to reach their long-term objective. Trustee boards will continue to have complex decisions to make about whether and how to use LDI. The experience of September 2022 indicates some will face challenges doing so. TPR should require trustees to report certain data on their use of LDI and should develop a strategy for engaging with schemes based on the results more closely.
8. 8
   TPR inadequately managed risks from complex leveraged LDI encouraged for pension trustees. Conclusion · paragraph 91 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   TPR encouraged pension scheme trustees to use leveraged LDI, which involves complex financial instruments. It continued to rely on them as the first line of defence to manage the risks, despite its longstanding concerns about governance standards in some schemes, particularly smaller ones which do not benefit from economies of scale. As the regulator, with responsibility for standards of governance in workplace pension schemes, TPR was the second line of defence. It issued guidance on managing the risks of LDI but was not able to monitor whether that was being followed. It should have focused earlier on the risks of encouraging trustees to use such complex financial products and worked with DWP to consider what further action was needed to mitigate the risk.
9. 9
   Respond to the DB consolidation consultation and prioritise improving trustee regulation and governance standards. Conclusion · paragraph 99 · addressed to Department for Work and Pensions Conclusion (the committee's words)

   TPR told us that scheme consolidation would help improve scheme governance, by reducing the number of small schemes. However, consolidation needs to be into a safe vehicle, which requires legislation. DWP consulted on DB consolidation in 2018 but has still not responded to this. Another long-standing question has been whether to require some form of qualification for at least some trustees. As a first step to improving governance, DWP should respond to its consultation on DB consolidation no later than the end of October 2023. It should then work with TPR as a priority to improve the regulation of trustees and standards of governance, as it has said it intends to do. Given the time it will take to consult on, legislate for, and Defined benefit pensions with Liability Driven nnvestments 49 implement measures to improve governance, DWP should consider whether the use of LDI could be restricted, for example, based on a test related to a trustee boards’ ability to understand and manage the risks involved.
10. 10
    Bring forward plans to bring investment consultants within the FCA regulatory perimeter. Recommendation · paragraph 105 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    We heard, including from the FCA itself, that in some cases investment consultants were giving standardised advice, rather than thinking through what was best for the individual pension fund. Given the complexity of the decisions trustees are required to make, this is a concern. The Government should bring forward plans for investment consultants to be brought within the FCA’s regulatory perimeter before the end of this Parliament.
11. 11
    Work with the FCA to review effective implementation of LDI fund guidance for trustee monitoring. Recommendation · paragraph 108 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    To play their part in monitoring LDI, trustees need timely and accurate information from LDI funds and advisers. We welcome the fact that the FCA issued guidance on this in April. TPR should work with the FCA to review whether the guidance the FCA issued to LDI funds in April has been implemented effectively and is providing trustees with the simple mechanism for monitoring LDI that the FPC said was needed.
12. 12
    Report back on LDI resilience monitoring plans and TPR's digital transformation timeline. Recommendation · paragraph 124 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    TPR is working to become a more digitally enabled and data-led organisation but has a long way to go to achieve this. We support the Financial Policy Committee’s recommendation that TPR should specify minimum levels of resilience for the LDI arrangements in which pension schemes may invest and work with other regulators to ensure these are maintained. TPR does not have the data to check whether its guidance is being followed. DWP and TPR should report back to us by the end of October 2023 on how they plan to monitor whether LDI resilience is being maintained. They should also set out a timeline for TPR’s commitment to become a more digitally enabled and data-led organisation, with plans to resource it.
13. 13
    Consult on introducing LDI disclosure requirements for pension schemes to improve governance. Recommendation · paragraph 127 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    In addition to putting in place mechanisms to provide real-time warning of reductions in LDI resilience, the Department for Work and Pensions and The Pensions Regulator should consult on whether introducing disclosure requirements on pension schemes relating the use of LDI through the annual report or investment statement, would help improve standards of governance. They should consult with stakeholders on the data it is appropriate to collect. We suggest that consideration is given to: the maximum leverage allowed in the LDI funds in which the scheme is invested; the type of LDI they invest in; compliance with minimum resilience levels; and data on the pension schemes’ asset allocations, by growth and matching assets. If they conclude that requiring pensions schemes to report regularly on their use of LDI would place an undue burden on some schemes, TPR and DWP should explain the basis for allowing such schemes to continue to use leveraged LDI.
14. 14
    Report back on plans for analysing LDI data implications with other regulators. Recommendation · paragraph 137 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    Given the extent of leverage and the concentration of DB investments, more should have been done to follow up on the risks identified in 2018 by the Bank of England. Collecting better data on LDI is part of what is needed to improve management of systemic risks in future. It will also be essential that DWP and TPR work with other regulators and the Bank of England to analyse its implications. DWP and TPR should report back by the end of October 2023 on how they intend to ensure this happens.
15. 15
    Report back on giving TPR a financial stability remit and ensuring its capacity. Recommendation · paragraph 140 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    When the LDI episode arose, the Bank of England had to intervene to prevent financial instability. The regulatory framework was complex and fragmentary, and not fit for purpose when it came to managing systemic risks. The Financial Policy Committee recommended that TPR should have the remit to take into account financial stability considerations. Given the events of September 2022, we tend to agree, although it depends on what it means. One possible model would be for TPR to be a source of key information, able to proactively identify potential risks in the sector and then work with other regulators to analyse the implications. DWP should report back to us by the end of January 2024 on how it proposes to take forward the FPC’s recommendation that TPR be given a remit to take account of financial stability considerations and how it plans to ensure that TPR has the capacity and capability to deliver on this.
16. 16
    Halt plans for new funding regime until full impact assessment is produced. Recommendation · paragraph 149 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    There are two fundamental concerns with the new funding regime. One is that the approach is not sufficient to allow open schemes to thrive. This is an issue to which we will return in our wider inquiry on defined benefit pension schemes. The second is that it will result in greater ‘herding’ in investment decisions. In light of the FPC’s recommendation for TPR to take account of financial stability, DWP and TPR should halt their existing plans for a new funding regime, at least until it has produced a full impact assessment for the proposals, including the impact on financial stability and on open DB schemes.
17. 17
    September 2022 demonstrated systemic risks from DB scheme investment strategies. Recommendation · paragraph 150 · addressed to Department for Work and Pensions Recommendation (the committee's words)

    The September 2022 episode demonstrated the potential for the investment strategies used by DB schemes to give rise to systemic risks. While action has been taken to address some of the weaknesses which were exposed in this episode, there is still more work to be done. In this Report we have therefore set out some key areas for change that should be taken forward principally by DWP and TPR. We look forward to seeing their responses to our proposals.