Pensions and LDI Strategies—the missing element of legal risk

Recent press coverage of market turbulence linked to the role of Liability Driven Investment (‘LDI’) strategies in UK pension funds provides some interesting perspectives and context on the emergence and evolution of this trend. However, an issue which has been absent from the discussion is the role of legal risk linked to the fiduciary and other legal duties of pension fund trustees and asset managers. While that issue emerged in earlier discussions about the ‘greenium’ attached to the green gilt issue in the UK in autumn 2021, LDI strategies were not a central focus of that debate albeit that green gilts appear to have been bought by asset managers with discretionary LDI mandates.

Legal risk in connection with LDI strategies potentially arises in two forms. One is related to the fiduciary duty of pension fund trustees (and asset managers acting on their behalf) to exercise their powers for a proper purpose. The appropriate question to be asked in this context is why a LDI strategy is adopted and the conventional answer would be that it minimises fluctuations in the net funding position of a pension fund (the difference between its assets and liabilities). Viewed simply in those terms, LDI strategies can be characterized as a prudent exercise in risk management. But two other considerations are also relevant in this context. The first is one of the key drivers of the emergence of LDI strategies, which was the requirement for employers to report pension fund deficits or surpluses on their balance sheets. In that sense LDI responded to the desire of employers to mitigate volatility in their balance sheet and share price, with knock-on effects for related issues such as capital raising and executive remuneration. The financial stability of the employer may well bring long-term security to pension fund beneficiaries, but it is less clear that the long-term shift in assets from equities to fixed interest associated with this trend was in the interest of beneficiaries as some of the growth potential associated with equities was lost.  And even if the shift to LDI strategies might mitigate some of that risk through asset allocation and hedging, there remain questions relating to the degree of risk attached to that process. While setting the risk appetite requires consideration of a wide range of issues in the context of a specific pension scheme, the use of LDI strategies in principle opens up the other dimension of legal risk which is the duty of care required from pension trustees and asset managers acting on their behalf in investing fund assets.

The duty of care owed by pension trustees in respect of the investment of pension fund assets is nowadays a combination of the common law standard referencing the concept of prudence and more specific statutory obligations derived from the Pensions Act 1995 and related regulations. Case law has recognized that risk must adapt to current economic conditions and contemporary understanding of markets and investment, including the recognition that risk should be viewed in the context of the portfolio as whole. Thus, while a shift to LDI strategies might well be situated within those parameters, reports that recent market turbulence threatened the solvency of some pension schemes  suggest a degree of risk taking that may not have been appropriate. Two analogies, albeit not precisely aligned in terms of the investment context and applicable legal rules, provide some insight. The first is the ‘greenium’ applicable to green gilts, which seems to have constrained pension fund investment due to concerns over legal risk linked to fiduciary duty  as a result of the small premium attached to ‘green’ by comparison with comparable conventional gilts. That suggests a degree of risk aversion that does not seem to have been replicated in the evolution or implementation of LDI strategies. The second analogy is to re-imagine the threat to pension fund insolvency resulting from LDI strategies as a threat to the solvency of the employer’s business resulting from the actions of the directors. A comparable albeit differently formulated set of legal rules would be triggered in this context (corporate fiduciary duty and duty of care), but it seems less likely that issues of legal risk and liability would be ignored in this context, not least since creditors would often be more powerful drivers of action than pension fund beneficiaries.

None of this is to suggest that there is a manifest case of breach of fiduciary duty or duty of care in any specific instance of the move to LDI strategies or its implementation. It’s more a case of there being two takeaways from the LDI-linked market disruption in relation to legal risk; the first is that risk aversion and risk management can trigger legal risk; and the second is that aversion to legal risk seems unevenly spread across comparable actions in the financial and real world.

Iain MacNeil is Professor of Commercial Law at University of Glasgow.