FCA demands tougher tests for pension funds after gilts chaos

Asset managers using pension investment strategies at the heart of last year’s gilts market blow-up will have to run tougher stress tests and improve their risk management, in reforms aimed at beefing up the sector’s resilience to market shocks.

The Financial Conduct Authority on Monday published guidance for managers of pension funds that use Liability Driven Investing, after finding “significant deficiencies” in the management of multiple risks in such funds.

LDI strategies were designed to help pension funds reduce funding volatility, but schemes were forced to dump tens of billions of pounds of UK government bonds within days last September to meet urgent demands for cash from LDI managers.

The fire sale threatened to destabilise the UK’s financial system after gilt yields jumped sharply in response to the government’s disastrous “mini-budget” under then-prime minister Liz Truss.

Deficiencies exposed during the near-meltdown included the management of multiple risks in LDI funds, including stress testing and scenario planning, communications and client servicing, and operational arrangements, said the FCA.

“Cumulatively, these contributed to the market dysfunction and the consequent threat to financial stability,” it said.

Sarah Pritchard, executive director for markets at the FCA, said asset managers “must take the necessary steps” so that their LDI portfolios are resilient to future market volatility.

Pritchard added that although LDI strategies were now much more resilient following improvements made since September, there was “more to be done”.

The FCA said more robust stress tests were needed because the current arrangements to deal with liquidity risks, such as the enlargement of cash safety buffers held by LDI funds, provided only “a partial solution to address vulnerabilities”. 

It said asset managers should set liquidity buffers for each sub-fund within an LDI strategy that would allow funds to withstand “severe but plausible” stresses in the gilt market, and ensure they could meet any additional demands for cash for margin and collateral.

The Bank of England said in March that LDI funds should be able to withstand a sudden increase in gilt yields of at least 250 basis points.

Investment managers will remain responsible for developing their own stress tests but the FCA said these assessments and contingency plans to deal with adverse market conditions should be reviewed regularly and updated if there were significant changes in circumstances.

The regulator also wants investment managers to take greater responsibility for ensuring that pension scheme clients are using the right LDI strategy, for instance a pooled or segregated fund. Segregated funds proved more resilient during last year’s crisis.

Asset managers should also give “full consideration” to conflicts of interest that arise in running LDI strategies, including how they balance their own priorities against those of their clients and the allocation of resources to different clients, said the FCA.

The Investment Association, a trade body for investment companies, said asset managers had already made progress in delivering improvements in the resilience of LDI strategies.

“We will work with the regulators and our members to help firms take the necessary steps to deliver the additional resilience requirements that regulators are seeking,” said Jonathan Lipkin, IA director of policy, strategy and innovation.

Simeon Willis, chief investment officer at pension consultancy XPS, said the FCA was setting a “higher bar” for standards that would result in greater accountability for all of the decisions made by investment managers about LDI strategies.

“A theme running through the FCA’s announcement was that all participants must share greater responsibility for the appropriate LDI arrangements to achieve the end investor’s intended outcome,” said Willis.

Steve Hodder, a partner at pension consultant LCP, said the FCA’s guidance would make the LDI market more robust but added that the measures were largely aimed at formalising new standards that had already been implemented across the industry.

“There is an element of closing the stable door after the horse has already bolted,” said Hodder.