As most of the nation tries to forget the market chaos of the end of September 2022, the pensions industry is continuing to analyse what happened. There is plenty of blame to go around and no shortage of finger pointing.
Indeed, on 24 October 2022, the Work and Pensions Committee launched its inquiry into the regulation and governance of pension schemes with liability-driven investment (LDI). The committee is asking why LDI, if it is so flawed, was relied on so heavily.
It is more accurate to say that the concept of LDI is not inherently ‘wrong', but not all LDI strategies are the same. LDI has proved to be very effective for some schemes in the past but where LDI strategies involved layering unreasonable leverage on top of LDI, those schemes may have suffered losses as a result.
As for whether, from a professional negligence perspective, the adoption and approach to LDI was ‘right' for that scheme would depend on the strategy and circumstances of that scheme. Some schemes, and even their members, were simply in the wrong place at the wrong time, with many trades, transfers out, and other projects, becoming more costly or less valuable than originally envisaged. The potential claims arising would depend on the advice provided and contracts in place.
For many schemes, potential claims may have arisen from the investment manager taking urgent action during the crisis to raise cash in a so-called firesale which, unfortunately, may have caused the scheme losses.
In order to challenge those actions, trustees could argue that the specific trades to raise collateral were inappropriate. The success of such a claim would depend on what the scheme's position was at the time, and what options and assets were in fact available to the investment managers.
What the investment managers were required to do under their contract may well be a different question to what they ought to have done, with the benefit of hindsight - and indeed whether another reasonably competent investment manager in their position would have done what they did. Particularly in larger schemes, there were likely to have been various investment consultants and asset managers involved. Their liaising with each other, and the extent to which they were required to liaise, will no doubt be important. Where the investment manager was simply exercising discretion available to them, in difficult circumstances and seeking to avoid defaults, they may have a good defence.
The devil will be in the detail of such cases - and significant sums could turn on such detail. The strongest of such claims will always be where the investment managers failed to follow instructions provided, adhere to their contracts, or apply mandates issued to them. Schemes would do well to remember the importance of their instructions and contracts, particularly where there are multiple advisors and managers involved. Good governance arrangements will help to avoid gaps between these advisors, and to ensure roles and responsibilities are properly understood.
Investment managers may seek to argue the effects of the mini-budget were unforeseeable. The market moving in an unforeseeable way is itself a foreseeable event, hence the hedging strategies adopted by schemes and the reliance placed on investment managers to act. But, by any measure, what happened in September/October 2022 was a material event. The success of that defence will, once again, depend on the strategy and advice provided - and the contract of course.
There used to be an assumption that investment consultants and fiduciaries tend to 'get away with it' when investments do not perform as well as one would have hoped. After all, some risk-taking is an inevitable part of investing and seeking asset growth. However, trustees are becoming increasingly savvy at instructing and monitoring their investment managers. Trustees who suspect something might have gone wrong with their scheme will now need to be even more savvy by asking investment managers the right questions to establish whether losses have in fact been suffered. The nature of this type of claim is that the party which is in the best position to identify and calculate the loss is often the same party which may have caused them.
Whether or not claims are pursued, there is plenty of scope for relationships between trustees and investment consultants to be damaged - or indeed improved - depending on how they act now in the management of these claims.
Chris Edwards-Earl is pensions managing associate at Stephenson Harwood
Liability-driven Investment (LDI)
Trustees seek to ensure that the assets of the scheme meet their liabilities, through asset outperformance and contributions from employers.
LDI is designed to help trustees manage exposure to interest rates and inflation risks, and to maintain funding stability. LDI funds provide schemes with leveraged exposure to longer-term gilt yields (ie lower long-dated gilt prices). By the end of this year 60% of trustees were using it, and indeed The Pensions Regulator played a lead role in promoting its importance.
The sudden rise in gilt yields in September 2022 meant that the derivative contracts underlying LDI strategies exposed pension funds to a selling frenzy, as investment managers sought to raise cash to fund their margin calls. This in turn drove up collateral requirements at the same time as other investment managers were doing the same thing. The Bank of England stepped in to purchase bonds to restore stability.
In the wake of the crisis, some schemes were left ahead - the country's 5,000 corporate-backed schemes now have an aggregate surplus of close to £300bn. Other schemes, however, were not so lucky and are left asking their advisors and fiduciary managers why they did not fare so well.