British regulators failed to properly monitor the risks created by the derivatives-based investment strategy that upended the U.K.’s pension sector last year, an investment approach that poses a continuing risk to companies if changes aren’t made, according to a U.K. legislative panel.

Liability-driven investments, known as LDIs, invest in derivatives that are tied to U.K. government bonds known as gilts. They help pensions match long-term liabilities they have to retirees with less capital than they would need had they owned regular long-dated gilts. That allows them to manage exposure to changes in bond yields and free the funds’ balance sheets to invest in higher-returning investments such as stocks, real estate or private equity.

But LDIs expose pensions to losses if rates shoot up quickly, and many became unmoored in late 2022 when yields on gilts jumped after the government announced sweeping tax cuts last September. Bond prices fall as yields rise.

The resulting pension crisis spurred the Bank of England to start offering an emergency bond-buying intervention worth up to £65 billion, equivalent to around $78 billion. It also prompted regulators and policy makers last year to start calling for action to address the risks related to LDI strategies. As the crisis unfolded, U.K. pension funds began rushing to raise cash to satisfy collateral calls triggered by the moves on the government bonds.

The House of Lords industry and regulators committee, meanwhile, in October launched an investigation, culminating with a letter to members of government this week stressing the need for changes to avoid a repeat occurrence. The letter, dated Feb. 7, was sent to the U.K. government, the Bank of England, which is responsible for running the gilt market, and relevant regulators including U.K. watchdog the Pensions Regulator.

The committee, which in part scrutinizes the work of government agencies, said regulators failed to sufficiently focus on the risks associated with LDI strategies. LDI strategies, especially those that use leverage, were a solution created in response to an “artificial problem” from an accounting requirement that drives companies with pensions to focus on current as opposed to long-term estimates of pension deficits, according to the letter signed by committee Chair Clive Hollick.

This meant that while interest rates were falling, pension funds benefited. When rates rose, however, sharp losses followed, destabilizing the pension market, the letter said.

The government should adopt accounting standards for companies and pension funds that reflect the long-term nature of the plans while avoiding the need for leveraged LDI strategies, Mr. Hollick said in an interview. Trying to assess medium- and long-term liabilities with an instrument that has to be measured daily creates significant risk, he said. “There needs to be a kind of review of how much should be put into these types of derivatives.”

What’s more, pension regulators were encouraging pension funds to adopt LDIs and some pension funds were likely unaware of the potential risks stemming from the LDI strategies, making them reliant on advice from investment consultants, Mr. Hollick said. But this guidance is currently unregulated and may not cover a whole pension portfolio, he said. There should additionally be stricter limits and reporting on the amount of leverage allowed in LDI funds, the committee chair said.

Pensions have been pouring funds into LDIs over the years, even as warning signs emerged that some plans using LDIs were exposed to dramatic increases in interest rates. Pensions and others had invested £1.6 trillion in LDIs by 2021, up from £400 billion in 2011, according to the Investment Association, a trade group that represents investment managers in the U.K.

The LDI strategy was sensible and worked well until interest rates shot up, Mr. Hollick said. “There were no flashing lights anywhere to cause anyone to say, ‘Well, wait a minute, maybe we should pull back a bit.’”

This meltdown—a “near-death crisis”—has brought focus to the risks and should prompt action to avoid another similar crisis, the committee chair said. There is also, he said, the threat of a broader impact. “This can seep into the main market. Once you have a meltdown in gilts, immediate action has to be taken to stop a more systemic problem,” Mr. Hollick said.

The Bank of England is expected to weigh in later this month on the fallout from last year ahead of a parliamentary hearing in March on concerns that have been raised on LDI strategies.

Government representatives are expected at the March meeting to share thoughts and proposals in response to the crisis, Mr. Hollick said. “If these problems aren’t taken seriously and looked at, you run the risk that something like that will happen again,” he said. “And that’s not a good place to be. Pensions are supposed to be on the safe side, not the racy side.”

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