The Pensions Regulator (TPR) has published new guidance on the practical steps UK trustees should take to manage risks when using leveraged liability-driven investments (LDI), following market volatility in autumn 2022.

As reported by our sister publication Pensions Age, TPR confirmed that it expects trustees to only invest in leveraged LDI arrangements which have put in place an appropriately sized buffer, clarifying that this must include an operational buffer specific to the LDI arrangement to manage day-to-day changes, in addition to the 250 basis points minimum to provide resilience in times of market stress.

The regulator explained that setting the right buffer level is “essential” to ensure that the fund can operate in the normal way even where there are sharp market movement, acknowledging that the right buffer will depend on the composition of the LDI arrangements and the operational processes which surround it.

TPR’s new guidance also outlines specific steps trustees should be taking when investing in LDI, including where LDI fits within a scheme’s investment strategy, testing for resilience, and setting, operating and maintaining a collateral buffer.

In particular, TPR emphasised the importance of having the right governance and controls in place to reduce risks to schemes, and to be able to react to events quickly, urging trustees to make sure there are processes in place for monitoring the resilience of LDI arrangements.

It also emphasised that trustees should understand what monitoring their advisers or the LDI managers perform routinely and put in place mechanisms to ensure they receive necessary and sufficient information to understand and be able to react to risks.

Although TPR acknowledged that LDI is technical in nature and trustees will need input from advisers, it clarified that trustees should also take steps to ensure that those advising or supporting them have the appropriate knowledge and experience to do so, and put the right controls in place around their services.

The regulator also clarified that the guidance applies regardless of the type of investment used for LDI, whether this is pooled funds or segregated LDI.

Commenting on the guidance, TPR interim director of regulatory policy, analysis and advise, Lou Davey, stated: “Many schemes use LDI as a tool to mitigate volatility risks and we continue to monitor the use of this type of investment.

“The unprecedented market volatility seen last September clearly demonstrated there is the need for stronger buffers, more stringent governance and operational processes and more oversight by trustees.

"Trustees must understand the risks they carry in their investment strategy, and only use leveraged LDI if appropriate. Our guidance provides practical steps to ensure they achieve this vital balance, and we expect trustees to use it.”

Alongside TPR's update, the Financial Conduct Authority (FCA) has published a series of recommendations for asset managers designed to increase resilience of LDI funds, confirming that it will continue to work with regulatory partners in engagement with this sector.

FCA executive director, markets. Sarah Pritchard, stated: "We have been clear that asset managers must take the necessary steps so that their LDI portfolios are resilient to future market volatility.

"Since September last year, we have been closely monitoring asset managers using LDI strategies as they make improvements and the sector is now much more resilient to potential risks, but there is more to be done.

"This guidance sets out what we expect in terms of risk management, stress testing and client communication, so that the necessary lessons are learned from last September’s extreme events. Many of these lessons will be relevant to firms beyond the LDI sector."

TPR's guidance is in line with previous recommendations from the Bank of England’s Financial Policy Committee (FPC), which urged TPR to take action “as soon as possible” to mitigate financial stability risks by specifying the minimum levels of resilience for LDI funds and LDI mandates in which pension trustees may invest.

Industry experts previously suggested that the FPC's recommendations were not a surprise and won't have a major impact on LDI funds, although experts acknowledged that the "devil's going to be in the detail".

The updated guidance also follows interim guidance from TPR, which had encouraged scheme trustees who use LDI to maintain an "appropriate level of resilience" in leveraged arrangements to better withstand a fast and significant rise in bond yields.

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