The Pensions Regulator on Trial

LDI Strategies: The Pensions Regulator on Trial Presented by: Professor Ian Clacher (Professor of Pensions & Finance and Director of the Centre for Financial Technology and Innovation) Date: December 12, 2022 No Body Could Have Predicted 21/09/2022 22/09/2022 23/09/2022 26/09/2022 27/09/2022 28/09/2022 22/11/2036 Dirty -0.18% -3.08% -3.21% -7.18% -8.05% 9.50% 22/03/2039 Dirty -0.20% -3.35% -3.56% -8.49% -9.99% 13.39% 15 Year Zero -2.57% -2.50% -3.06% -4.84% -4.58% 8.56% - The initiation of the event sequence was not extreme. - The Bank rate increase and QE announcement affected only conventional. - ILG selling is pension scheme LDI portfolios. - Stressed to 100 bp - comparative statics should be risk dynamics CAR and Accounting Amortization What is LDI? - LDI was concerned with matching the variability of liabilities with similarly variable assets. - Most of the variability of the present value of pension liabilities stems from the discount rate used. - Note that to achieve this matching, pension assets must be riskier than pensi liabilities. - A second objective was introduced, to repair scheme deficits - Assets must become riskier still. - The way chosen to square these two objectives was to: 1) Lever the asset portfolio 2) Divide into matching and growth sub-portfolios - Leverage is achieved using Interest Rate Swaps and Repo - Is such management legal? Asset & Liability Management  Standard ALM is concerned with protecting equity.  From the aggregate risks to equity from assets and liabilities.  Note that assets > non-equity liabilities  The firm may have leverage through bonds or loans  With a surplus of assets to liabilities we may match the non-equity liabilities with assets  And have a surplus to pursue growth  But the Regulator looks to Scheme Funding, not Sponsor Covenant  Funding trumps Covenant  They do not consider sponsor covenant to be an asset of the scheme. Holistic View of Risk  The analysis should be of scheme and company sponsor  It should be of Equity exposure to  The aggregate of:   Corporate Debt  Business Liabilities  Pension Liabilities  Business Liabilities  Pension Liabilities Interest rates (Discount rates) do not figure in the determination of the pensions ultimately payable by a scheme.  They do determine a trajectory or amortization schedule for liabilities.  This interest rate risk is perceived but not real  These rates merely determine a present value for those projected benefits  In and of themselves their variability does not matter unless we base decisions and actions upon them.  Even hedging using conventional gilts actually introduces a dependency, a risk, on the performance of gilts (interest rates) into the scheme.  Schemes will gain when rates decline and lose when they rise.  Is this legal? The Law – Borrowing - Borrowing - IORP II, Art 19 The home Member State shall prohibit IORPs from borrowing or acting as a guarantor on behalf of third parties. However, Member States may authorize IORPs to carry out some borrowing only for liquidity purposes and on a temporary basis. - The Occupational Pension Schemes (Investment) Regulations 2005 (OPS, 2005) Borrowing and guarantees by trustees  5.-(1) Except as provided in paragraph (2), the trustees of a trust scheme, and a fund manager to whom any discretion has been delegated under section 34 of the 1995 Act, must not borrow money or act as a guarantor in respect of the obligations of another person where the borrowing is liable to be repaid, or liability under a guarantee is liable to be satisfied, out of the assets of the scheme.  (2) Paragraph (1) does not preclude borrowing made only for the purpose of providing liquidity for the scheme and on a temporary basis. Borrowing  Repo  Economically this is secured borrowing. It effectively subordinates the interests of scheme members  It has been widely utilized in the financing of long positions in conventional and index linked gilts-edged securities.  The repurchase leg clearly satisfies the statute implied test of borrowing - of repayment from the scheme's assets.  Schemes have been borrowing for long terms and in amounts far in excess of their liquidity needs.  ICMA - the principal use of repo is in fact the secured borrowing and lending of cash.  But TPR baldly states: "We understand that repo financing is structured as a sale and future repurchase of an asset and, as such, would not amount to borrowing for the purposes of the Investment Regulations".  The Bank of England does not agree: "LDI strategies enable DB pension funds to use leverage (i.e. to borrow) to increase their exposure to long-term gilts, while also holding riskier and higher-yielding assets such as equities in order to boost their returns." Are Repos Derivatives? - No mainstream finance texts make this claim - We found just one paper supporting this concept - (Is the repo a derivative? A. P. Faure, Rhodes University, June 2011) - EMIR: "A derivative is a financial contract linked to the fluctuation in the price of an underlying asset or a basket of assets." - However, we would note that repos are not derivatives of the underlying securities - But rather operations on those securities, (their sale and purchase) • For the purpose of borrowing money. - But, in the Investment Risk Appendix to the (PPF) Board's Determination under Section 175(5) of the Act: - 30. Gilt derivatives include gilt repos