Resilience standards
The LDI arrangements you invest in need to be resilient to short-term adverse changes in market conditions. To do this, cash, cash equivalents and assets are held as a ‘buffer’, which can be drawn on by the fund manager if additional collateral is called for as a result of changing market conditions. Only assets that can reliably be sourced or converted to eligible collateral in a timely manner should be held in the buffer.
As a trustee, you should make sure the arrangements you invest in operate an appropriate buffer, and that the right processes are in place for drawing on and replenishing the buffer.
There are two elements to consider in the buffer:
- Having sufficient liquidity to manage day-to-day volatility in the market (an operational buffer).
- Additional liquidity to provide resilience during severe market stress (a market stress buffer).
These elements are cumulative. If an arrangement’s operational buffer is set at 100 bps, and the market stress buffer at 250 bps, the total buffer the arrangement needs to operate is 350 bps.
In pooled funds, the buffer will be set by the fund manager. In segregated funds it will be set by the LDI manager and the trustees. In either case, you should satisfy yourself that the buffer provides sufficient resilience and is operable with your scheme’s governance arrangements.
Operational buffer
A smaller operational buffer means you may be called upon more frequently to provide additional capital to replenish the buffer. A larger operational buffer reduces the frequency at which this might happen, but ties up more of your assets in collateral, with associated implications for your scheme’s investment returns.
When assessing the appropriateness of the operational buffer, you should consider the following:
- Volatility in the gilt market —a highly volatile environment might put a lot of pressure on low buffer arrangements.
- How quickly and effectively assets can be accessed, sold or otherwise converted to cash to replenish the buffer. Slower, more complex processes might require a large buffer.
- The cost of making asset sales to meet collateral demands or replenish the buffer. Frequent sales as a result of a small buffer would incur greater costs.
The operational buffer should at least reflect gilt yield volatility in normal market conditions.
Market stress buffer
The LDI arrangement should also operate a market stress buffer, so the fund can operate as business as usual even where there are sharp market movements. This buffer should be, at a minimum, 250 bps. This minimum level assumes you are able to provide additional cash or assets to replenish the buffer within five days. If it is likely to take you longer, a larger market stress buffer may be appropriate. A larger market stress buffer may also be appropriate in other circ*mstances, for example if the assets held within the buffer are more volatile than assets typically held in LDI arrangements. Similarly, if the composition of the LDI fund is intrinsically less volatile than a gilt related LDI fund, it may be acceptable to use a lower market stress buffer.
The 250 bps minimum resilience level should be maintained in normal times but can be drawn down on in periods of stress.
Maintaining the buffer
You may be called upon to provide additional cash or assets to replenish the buffer if it drops too low. You should understand the thresholds or conditions under which these ‘cash calls’ will take place, put in place processes for meeting these calls, and record these processes (for example in a collateral management policy).
You may want to specify which assets can be sold for raising cash in pre-agreed instructions to be shared with relevant parties. You might do the following:
- Use a single fund to raise cash.
- Use a pre-specified portfolio of assets to raise cash.
- Use a waterfall of funds, ie using the first fund for cash until it is exhausted, followed by a second fund, third fund and so on.
You should assess and understand the risks associated with each of the above options in terms of your ability to meet cash calls quickly, and the complexity and costs associated with the sales process.
When determining which assets to use, you should consider the time it takes to sell these assets (including the time needed to make the decision, notice periods and settlement times). LDI managers will expect calls to be met within a certain timeframe (typically within five working days). You should speak to your managers about their timeframes (in normal times but also in times of stress) and make sure that the assets you use to meet cash calls will be able to be sold within those times. You should be mindful of how stressed market conditions may impact their liquidity and operational availability. You should also consider how the value of the assets is impacted by market movements —if the circ*mstances which lead to a cash call are also likely to lead to a reduction in value of the assets, they may be less suitable to use.
You may also be able to rely on other sources of cash to replenish collateral, for example through a short-term line of credit with your sponsoring employer(s) or repurchase agreements. Such arrangements should be documented and reviewed regularly to ensure they remain in place and clearly reference the time period, amounts and conditions. You should make sure any arrangement is reviewed legally to ensure the facility will be available when it is needed.
You should be clear on the process for selling the assets: who is authorised to sell them and under which circ*mstances, who the instructions to sell need to go to and by when, and whether electronic or wet ink signatures are required.
You may decide to retain decisions on cash calls. In this case, you will need to make quick decisions. You need to keep a list of authorised signatories, review this periodically and amend it as soon as possible if a trustee resigns or is appointed. You should make sure you have a sufficient number of signatories to cover absences.
Alternatively, you can delegate the selling of assets to meet cash calls to the LDI manager, an investment platform, or a fiduciary manager. All delegations should be clearly defined and recorded, and appropriately reflected in legal agreements and contracts. There can be a squeeze on resources in extreme market conditions. Therefore, you and your advisers should regularly review the operational processes and resourcing of these service providers, paying particular attention to the use of technology, which avoids the need for manual intervention.
You need to consider how your processes work in the event of cumulative cash calls, especially if these arrive in quick succession. You also need to consider how you intend to top up these assets if they are sold, to ensure a continued supply of liquid assets to top up the LDI arrangement as long as this remains appropriate for your scheme.
Resilience testing
You should test the resilience of your LDI investments and processes. Your investment adviser or LDI manager will design these tests, but you should be confident that they are sufficiently robust and provide you with the information you need to understand the risks. You should record the outcome of these tests, and address areas of concern.
These tests should be done regularly (for example on an annual or triennial basis, alongside wider investment strategy testing) but also when there are significant changes to your scheme’s funding or investment position, or significant changes in market conditions.
Testing for resilience can be done in one of two ways:
- Looking at how your LDI arrangements and processes perform under different scenarios that are relevant to your investment strategy and vulnerabilities. These should consider a range of circ*mstances, for example market movements of different sizes, speed and duration. The tests should take a holistic view of the impacts, looking at:
- the impact on the LDI arrangement and collateral buffer
- the impacts on the assets you have earmarked to replenish the buffer
- the size of the cash call(s) that would need to be made, and any associated transaction costs
- how quickly transactions would need to be made, and how well your operational processes and those of your advisers/providers would be able to meet this; considering how long it takes to receive information, make a decision, instruct and taking into account the dealing cycle of assets
- the impact of dealing cycles, for example what happens if you have just missed the dealing cut-off point
- the impact on other assets or derivative instruments (such as equity or foreign exchange) where relevant
- if other schemes or parties are likely to be in the same position as you and looking to act at the same time (which could affect your ability to respond)
- the impact on your overall investment portfolio
- any risk to your ability to meet payment obligations such as benefit payments
- Determining the size of market movement required before a specific event would happen, for example when you would be called upon to replenish the buffer (the next cash calls) and how large a change is needed before you run out of the assets you have earmarked for replenishing the buffer.
