To ask His Majesty’s Government what assessment they have made of (1) the extent of Liability Driven Investment strategies in the management of Defined Benefit pension funds, and (2) the consequences that may arise for (a) His Majesty’s Government’s ability to issue new gilts, and (b) the management of inflation.
Defined benefit pensions use liability-driven investment strategies to protect themselves from adverse interest rate and inflation movements. The Pensions Regulator estimates that 60% of defined benefit pension funds have LDIs. The Debt Management Office’s gilt operations are running smoothly, with good levels of demand; its 2022-23 financing remit will be revised alongside the Autumn Statement on 17 November.
My Lords, I welcome my noble friend back to the Front Bench. If the pension funds were entering into those risky strategies with a view to eliminating their exposure to interest rate changes, it did not quite work, did it? The Government need to sell gilts to borrow money for their activities. The Bank of England needs to sell gilts to start to reverse quantitative easing and to bear down on inflation. Both those activities were threatened by the sudden discovery of what can only be described as risky and dodgy investment strategies at private pension schemes a few weeks ago. So what I and other noble Lords would like to hear from my noble friend is that those financial positions have now been reversed out of by the pension funds—that they are not pursuing those strategies—so that this does not happen again, and the Government and the Bank can continue with their vital activities.
My Lords, LDI strategies can be used as a risk-management strategy for pension funds, and I would expect them to continue to do so. There were specific circumstances which the Bank stepped in to address. But my noble friend is right that it is important that we reflect on what happened to those particular funds in that period and make sure that the Bank of England and the Financial Policy Committee have the right oversight to ensure ongoing stability in these markets.
My Lords, a key focus of the IORP directive, which was transposed into the Pensions Act 2004, was to prohibit borrowing so that assets are retained for the payment of pensions and not put at risk of being drained away to third parties. With that prohibition on borrowing, how has that been circumvented, permitting repos and investing in funds that break both the principle and detail of that provision? Is it not dishonest to describe LDI as de-risking when it introduced leverage and derivative exposures of some £1.4 trillion, which is nearly the same as the total pension fund assets?
My Lords, the Government do not agree with the noble Baroness’s assessment of the situation. Along with the Bank of England and the Financial Policy Committee, we keep a close eye on identifying and addressing systemic risks to improve UK financial stability. In 2018, the committee specifically looked at UK pension schemes’ resilience to an instantaneous 100 basis point rise in yields across maturities. The movements that we saw a few weeks ago were greater than that. As the FPC has also noted, it may not be reasonable to expect market participants to insure against all extreme market outcomes, because there can be negative effects to that as well.
My Lords, I declare an interest as a fellow of the Institute of Actuaries. I am afraid that there will be an alliance of regulators and providers who will say, “Nothing to see here, we can move on”. There are questions to be answered about what damage has been done and about what we can do to ensure that it does not happen again. There is so much hidden in the investment policies of pension funds. Can the Government give an assurance that there will be a proper investigation of what happened, with an independent element?
My Lords, the Pensions Regulator and other regulators have said that they will want to look at what has happened and learn lessons. I also understand that the Work and Pensions Committee in the Commons is looking at this issue, including any changes to the Pensions Regulator, for example, that may need to be made. The Government look forward to reading the results of its findings.
My Lords, is the potential booby-trap in LDIs not the liquidity mismatch between the time it takes to sell the assets of pension funds and the demands of the hedge, which requires the margins to be met on the same day in cash? Is that not a strong argument for the liquidity buffer to be increased? Does it not also pose the question: to what extent did QE force people more and more into these assets?
My noble friend is absolutely right about the liquidity mismatch. My understanding is that there was a certain amount of flexibility shown in that; none the less, the Bank of England’s intervention was directed to address that specific problem. As for the QE policy, my noble friend will not be surprised to hear me say that that is for the Bank of England and I will not comment further on it.
My Lords, obviously the shadow banking system, which includes insurers and pension funds, is not subject to the same rules as traditional banks, especially when it comes to holding cash reserves against market shocks. Does the Minister agree with Sir Jon Cunliffe, Deputy Governor of the Bank of England, when he wrote to the Treasury Select Committee in the other place recently to say that it is incredibly important that there should be more international checks and balances on non-banks?
My noble friend is absolutely right that there can be risks to financial stability from non-banking actors in the financial system and that they are not subject to the same regulations. He is also right that addressing some of these risks cannot be just through domestic action but must also be international action, and that is something the UK is advocating for.
My Lords, I welcome the noble Baroness, the Minister now, back to her seat and look forward to many one-to-ones. Financial regulators in a number of European countries have taken steps to increase surveillance of derivative-linked funds used by UK pension schemes. That is an attempt to promote international financial stability following the post mini-Budget market turmoil. Having witnessed recent events, does it remain the Government’s intention to water down UK regulators focused on stability by introducing a statutory requirement to prioritise competitiveness?
I thank the noble Lord, and all noble Lords for their welcome back, but I have to disagree with the noble Lord’s interpretation of the provisions in the forthcoming financial services Bill. Financial stability will remain at the core of our system, but I do not think it is wrong to also recognise the importance of competitiveness in that system.
My Lords, the Minister, whom I welcome, said that the Government had handed off to a committee of the House of Commons the responsibility for looking at whether reform of the Pensions Regulator was required. Surely, the Government should be looking at whether reform is required because, very clearly, we have a regulator that neither recognised the embedded risk of strategies that it was allowing pension funds to pursue, nor understood the broader implications. This suggests that change is urgent.
If that was the impression the noble Baroness had of my Answer, it was not the one I meant to leave with noble Lords. The regulators, including the Financial Policy Committee, the Pensions Regulator and others, will want to look at and reflect on the lessons that can be learned from the events of recent weeks. In pointing to the Commons committee’s work, I merely sought to address the noble Lord’s point about a different or more independent set of eyes also looking at this.
My Lords, can it be true that the Bank of England’s own pension fund had more than 80% of its assets invested in these highly risky derivative products, which depended on keeping interest rates down? Given that the Bank of England intervened to buy bonds to keep interest rates down, was there not a conflict of interest there? Also, was it not apparent to everyone, if these are the facts, that the system of regulation has failed—failed absolutely —and needs to be looked at again?
My Lords, I do not know how the Bank of England’s own pension scheme is invested. As my noble friend pointed out, the particular issue around these schemes was liquidity; the Bank of England stepped in to address that issue, which I believe has now been resolved. None the less, we will look at the lessons that can be learned. I pointed to an exercise undertaken in 2018 to stress-test UK pension schemes’ resilience, but the movements we saw in the past few weeks went beyond the bounds of those scenarios. We should reflect on that and see whether anything needs to change as a result.