Gilt yields soared and prices plummeted in September amid the then-government's announcement of unfunded tax cuts, leading to huge collateral calls for U.K. pension funds in order to keep their LDI hedges in place.
As a result, regulators asked that pension funds increase their collateral buffers — calculated using an assumption of how much liquidity they would need to absorb a move in gilt yields — to between 300 basis points and 400 basis points, from around 100 basis points or so.
The FPC on Wednesday, however, said it wants The Pensions Regulator to mandate an at least 250 basis points buffer for pension funds' LDI programs going forward.
While pension funds won't need to change anything immediately, since they're already operating at 300 basis points to 400 basis points, the requirement needs careful thought in order to avoid unintended consequences.
"Whilst I really do understand why it's important to have a minimum given the importance of pension funds to the (U.K.) gilt market, there's a slight danger with having a single number as the minimum for the entire industry. What happens as they approach the minimum?" said Nikesh Patel, managing director, head of client solutions and CIO at Van Lanschot Kempen.
While there may be "some nuance added" between the FPC's recommendation and it becoming a regulatory requirement, "there's a bit of danger if (regulators) refer to this as just a minimum," he said.
The danger is that pension funds with similar maturity profiles, for example, deplete their buffers at the same time and rush to make changes together.
"It just creates a danger that all the pension funds of a certain kind start recapitalizing at the same point. To my view, the risk to financial stability wasn't that (pension funds with LDI programs) had to recapitalize, or that interest rates (moved) so far so fast — it's that they all did it at the same time," Mr. Patel said.
"In the event (regulators) set a hard target, people will start setting hard rules and reduce flexibility," making a difficult market environment "even more volatile," Mr. Patel warned.
Another question is what the banks sitting on the other side of the LDI trades want. "They should have and will have a voice — so far we haven't heard it" as far as he is aware, Mr. Patel said.
A further consideration is the need to improve operational processes at pension funds. While that will be a challenge for some pension fund trustees, it presents an opportunity for professional and independent trustees, as well as for outsourced CIO providers, he added.
Regarding the TPR recommendation that trustees cannot invest in LDI strategies that operate with yield shocks of less than 250 basis points, Simon Daniel, partner at law firm Eversheds Sutherland, said in emailed commentary: "Issuing such prescriptive guidance will be new territory for TPR, but is the most direct and immediate lever available to the FPC given the non-U.K. domicile of all LDI pooled funds."
For now, trustees will have important details to work through, he said, such as assessing whether they can deliver collateral within five days of a call — one basis for the FPC's buffer recommendation. "This means that even greater resilience will be required if a scheme expects to need more time, with the buffer then being set according to the particular scheme's own operational timelines," Mr. Daniel said.
