LGPS and derivatives - removing the ambiguity?

The current position

Under the Local Government Pension Scheme (Management and Investment of Funds) Regulations 2009 (the “2009 Regulations”), local authorities are required to invest all fund money in “investments” (except where needed immediately to make payments from the fund). For these purposes, the term “investment” is stated as having its normal meaning. However, the regulation expressly provides that financial futures and traded options are “investments” and are therefore permitted.

The term “traded option” is defined to mean “an option quoted on a recognised stock exchange or on the London International Financial Futures Exchange”. “Financial futures” is undefined, but is generally used to refer to exchange traded forwards.

As such, while it is clear that financial futures and traded options are expressly permitted, it is uncertain whether other types of derivative are eligible or, by implication, that they are prohibited. Authorities have applied the regulations differently. While a number of authorities opt to enter into certain over the counter transactions to manage risks associated with their funds (in particular interest rate, inflation and currency risk), others refrain from doing so due to the risk of contravening the regulations. Authorities in both camps face risks: those who choose not to invest in hedging derivatives may expose their funds to unnecessary economic risk, while those that do invest run the legal risk of entering into transactions outside of their legal authority.

The uncertainty as to what counts as “investment” has long been criticised by the market and various industry bodies, including the Investment Association. The Financial Markets Law Committee wrote to the DCLG in October 2013 highlighting the legal uncertainty and suggesting a review of the regulations. Subsequently, the DCLG developed a working group to look into the existing rules, the findings of which informed the latest proposals.

The proposed new regulations

Through its consultation, the DCLG has proposed draft LGPS (Management and Investment of Funds) Regulations 2016, which have been developed in response to the DCLG’s May 2014 consultation and would revoke and replace the 2009 Regulations. The DCLG is proposing a “prudential approach” to investment policy (such as the requirement to publish an investment strategy statement as explained below), which is more closely aligned to the model that applies to trust based pension schemes.

The revised regulations would remove the current ambiguity by stating in the definition of “investment” that “a contract entered into in the course of dealing in financial futures, traded options or derivatives is an investment”.

The Government has said that it expects authorities to only use derivatives as a means of managing risk. As such, the DCLG is consulting on whether the regulation should explicitly state that derivatives may only be used as a risk management tool. The DCLG has also asked respondents to consider whether there might be other circumstances where the use of derivatives would be appropriate.

So as to ensure accountability, the proposed rules require authorities to prepare, take relevant advice on and publish an “investment strategy statement” in accordance with guidance issued by the Secretary of State. Certain information must be included in this statement, including evidence that the authority has assessed the suitability of particular investments and types of investment (eg specific derivatives) and the authority’s approach to risk. The draft regulations allow the Secretary of State to intervene in an authority’s investment functions if he or she believes the authority has not had due regard to the applicable guidance and regulations.

Next steps

The consultation opened on 25 November 2015 and runs until 19 February 2016. Following this, a Government response will be published within three months (ie by 19 May 2016) and, subject to the outcome of the consultation, the resulting regulations will be laid before Parliament.

LGPS and their managers may wish to respond to the consultation to endorse what appears to be a positive clarification of the law on LGPS entering into derivatives transactions and to provide feedback on whether the use of derivatives should be limited to hedging.

Other points to note

We are currently advising a number of clients on the European Market Infrastructure Regulation (EMIR) classification of LGPS and would be pleased to discuss this in more detail.