I heard it said, not so long ago, that TPR asks ‘silly’ questions. I’ll take the compliment, though I doubt one was intended. It’s one of the nice things about life here, that I get to ask questions. I’ve never (yet?) been so blunt as to ask: “Dear Trustees, what on earth were you thinking of when you set that investment strategy?” But it goes through my mind sometimes, based on pre-meeting paperwork.
The questions I do ask are things like: How do you justify that level of risk? What did your advisers have to say about it? What’s Plan B if it all goes wrong? Another question I like asking is “how’s the scheme’s plumbing?” If you needed to de-risk the investments quickly, could you do it? How up-to-date are all the signature mandates? And so on. Strategy and operations. They’re both important.
We talk a lot at TPR about the importance of trustees and their advisers. We can’t be everywhere at once and rely on trustees as a first line of defence. ‘Silly’ questions lead to interesting conversations. It’s why I ask them. Perhaps the investment strategy is making the best of a difficult situation. The risks are well-understood. They’re being monitored. Plan B can be implemented quickly and efficiently. Not every conversation goes like that, but it’s important not to generalise from those that don’t. They’re a biased sample. Many schemes are managing their risks well.
The strategy conversations have changed a bit in recent years. More and more of them are about liquidity management in maturing schemes. Income-generating assets. Liquidity waterfalls. The risks of forced disinvestment in depressed markets. We wrote about that in our defined benefit (DB) investment guidance back in 2017 as well as in our first DB funding code consultation in March 2020. We’ll have more to say on it in our second consultation due later this year.
The plumbing conversation is changing too. Not so much with individual schemes yet, but rather when we’re out and about, and in the press. How are schemes handling liability-driven investment (LDI) collateral calls? Were trustees well-enough prepared for them?
I mentioned earlier the importance of advisers. Another of the things I like about life at TPR, is that I get to read investment advisers’ reports. Really. It’s fascinating, as an investment consultant, to see the different ways advisers explain complex things in simple terms. “This is an LDI fund. You invest £100 in it, the manager uses derivatives to increase the market exposure by £200, and you end up with £300 in matching assets. This means that it’s leveraged three times, £300: £100. The manager will want to keep the leverage within tolerance limits. If interest rates fall, the leverage goes down. The manager might return some money to you. If interest rates rise, the leverage goes up. The manager might ask you for some more money to reduce the leverage. And you need a plan for dealing with this. Or else the manager will sell some of the matching assets to get the leverage back in line.” OK, I’ve simplified things. But the example I’m thinking of made very clear that collateral calls could happen.
Anecdotally, we hear that some schemes may have been under-prepared, after years of falling interest rates in which LDI funds were paying collateral back to schemes. But we know that advisers were making trustees aware of the risks, and our DB investment guidance covers it too. As earlier, it’s best not to generalise from biased samples. We remain vigilant to the risks and expect trustees to do the same.
I’ve highlighted operational risk because it’s important and, for once, topical. I could have chosen to talk about the implications of rising rates for investment strategy. Should schemes be reviewing their LDI strategies in the light of recent events? Of course. It almost goes without saying that we expect trustees to monitor their scheme’s investment, risk management and arrangements on an ongoing basis and take action as appropriate. As always, it’s important for trustees and advisers to work well together to manage scheme risks.
There are other questions too. Is liability hedging a good thing? Yes, we think that it is. If nothing else, most schemes will ultimately secure their benefits, and hedging protects against a rise in the cost of doing so. What about leverage? It’s fine if not done to excess, the risks need to be understood and managed, see above.
I started this blog by talking about asking ‘silly’ questions. Questions are rarely genuinely silly. They usually serve a purpose. Seeking a better understanding of trustees’ actions. Or of a regulator’s viewpoint.
Of course, all this just skims the surface of topics that deserve a much fuller treatment. I reserve the right to return to them and continue the discussion and debate (something else I like about life at TPR). In the meanwhile, if the questions in this blog have set you thinking about operational risks as well as strategic ones, getting good advice, and effective risk management, they’ll have done their job, silly or otherwise.
By Fred Berry
Lead Investment Consultant