In September 2022, the UK's central bank, the Bank of England, was forced to intervene in the gilt market to the tune of £19.3 billion after the UK Prime Minister at the time, Liz Truss’, “mini budget”. Gilt prices fell precipitously, which caused defined benefit pension funds operating a leveraged ‘liability driven investment’ (LDI) strategy to face cash collateral calls. To meet those calls, they sold their gilt holdings, thus further depressing gilt prices. Without the Bank’s intervention, gilt prices would have continued to fall, which may have led to pension fund insolvencies and would, in the Bank’s words, have caused “widespread financial instability”.

Regulators, legislators and commentators have been considering the role of LDI in light of these events. On 7 February, the UK's House of Lords' Industry and Regulators Committee (the Committee) issued its recommendations for legal and regulatory reform. The Committee’s recommendations, set out in a letter addressed to UK government ministers, are surprisingly – and arguably refreshingly – radical.

Most notably, and unlike previous statements from the Bank of England (e.g. here and here), the Committee questions the entire rationale of LDI. Mirroring criticisms made by commentators such as Matt Levine and Toby Nangle, the Committee explains that:

“the fundamental issue is that leveraged LDI has been created as a solution to an artificial problem created by accounting standards, but in the real world its application creates downside risks.”

The Committee’s argument here is persuasive. The way that funds account for the present value of their liabilities (that is, the value of the amounts they will need to pay to their scheme members) is based on a ‘discount rate’ that is a low-risk market interest rate. This means that, when the discount rate decreases (i.e. when gilt prices increase), the present value of funds’ liabilities increases by more than the increase in the present value of funds’ assets (which typically include some growth assets like equities). This, in turn, means that, as an accounting matter, funds are ‘short’ gilts.

LDI is a solution to this problem: by employing leverage, LDI enables funds to hedge against a rise in gilt prices. Note that the ‘problem’ here is fundamentally one of accounting: the actual drivers of the value of pension fund liabilities, such as the extent of the benefits, inflation and member longevity, are not affected by short-term swings in gilt prices. The ‘solution’ – LDI – is effectively a one-way bet on interest rates remaining low and when that bet goes wrong, it has all too real consequences as seen in September 2022.

The Committee’s broad scepticism of the utility of LDI leads them to make some robust suggestions for reform, such as:

  • a review of pension accounting rules, with a view to adopting a “less volatile, longer-term asset-led approach”, which would eliminate the accounting problem LDI was designed to solve;
  • amendments to the regulations governing how pension schemes invest, aimed at controlling more tightly investment in leveraged products;
  • a potential role for the UK's Prudential Regulation Authority in supervising pension schemes that engage in leveraged investment, particularly given the trend toward schemes being bought out by insurers; and
  • the UK government legislating urgently to bring pension scheme investment consultants (responsible for advising schemes to adopt LDI) within the UK Financial Conduct Authority's regulatory perimeter.

It remains to be seen how the UK government will respond to the Committee’s radicalism. But tighter regulation of pension schemes may yet prove to be the most enduring legacy of the Truss government’s short-lived deregulatory zeal.