It’s the end of the line for the London Interbank Offered Rate (LIBOR), the interest rate benchmark for many financial products since the 1980s. Sterling Overnight Index Average (SONIA), an alternative rate, will become the new benchmark of choice and pension schemes have been directed to step aboard pronto. What will the journey to SONIA look like and what stops will pension scheme trustees pass through on the way?
Where are we now?
LIBOR developed during the 1980s and originated from the need for a standard benchmark for interest rates across financial institutions. It is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds and is calculated by using banks’ submissions of their inter-bank borrowing rates. Calculated on a daily basis and in five currencies, LIBOR is widely used as an interest rate benchmark and written in to an array of legal contracts and financial products.
In the period since 2008, when concerns emerged during the financial crisis about inter-bank lending rates such as LIBOR being artificially manipulated, many reforms to LIBOR have taken place and regulator scrutiny has increased. However, banks no longer fund themselves in the way they once did. This has meant that LIBOR is now sustained by the use of “expert judgement” rather than an underlying active market. The Bank of England and the Financial Conduct Authority (FCA) announced earlier this year that LIBOR is “not considered sufficiently robust or sustainable given its widespread use”. As such, the publication of LIBOR rates is expected to cease after the end of 2021.
The Working Group on Sterling Risk-Free Reference Rates (RFRWG) was established by the Bank of England and the FCA in 2015 to oversee the transition in the UK to alternative benchmark rates for interest before the discontinuance of LIBOR. In 2017, the RFRWG selected SONIA as the preferred alternative to LIBOR for wholesale financial markets in the UK. SONIA is administered by the Bank of England and is based on actual transactions reported to it. It reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions.
SONIA is the preferred alternative to LIBOR because it is
- Founded on active, liquid underlying markets and therefore is a more accurate measure of the general level of interest rates
- Almost risk free, because it does not include any term bank credit risk or liquidity premium
- Suitable for use in around 90% of future sterling lending by value
In order to facilitate the transition to SONIA, the FCA has secured the agreement of banks which will continue to fund LIBOR until the end of 2021. Reliance on LIBOR after this will cause a number of issues; most notably, uncertainty over the legal position of contracts that refer to LIBOR rates. The Bank of England and the FCA are keen to avoid the risk of disorderly outcomes as a result of agreements continuing to reference LIBOR, with no permanent fallback provisions. As such, they have encouraged all stakeholders to actively progress the transition where necessary. The scale of the project should not be underestimated. The Bank of England reported in 2018 that LIBOR underpinned $30tn of financial contracts in GBP markets alone.
Relevance to Pension Schemes?
These developments are relevant to all financial products and contracts that reference LIBOR. This will include credit agreements but will also exist in pension scheme documents and indeed many other types of contract which have arrangements for payments which add interest. In particular, this will impact both present and proposed investment management arrangements where LIBOR is incorporated as a reference rate. It will not be appropriate to simply swap SONIA for LIBOR because the risk free SONIA rate will typically be lower. Replacement benchmarks may therefore be set at SONIA plus an agreed “spread” to reflect that difference.
Safe Journey to SONIA
Pension scheme trustees, with the help of their investment managers and legal advisors, will need to stop off at the following points on their journey to the replacement of LIBOR
- Identify LIBOR exposures and fallback terms (if any) within existing investment documents, such as investment management agreements
- Obtain advice on how the transition from LIBOR to SONIA should be managed, taking account of the fact that SONIA is not a like-for-like replacement for LIBOR
- Update existing contracts accordingly
Pension schemes should be taking action now to ensure that the end of LIBOR does not mean uncertainty about future obligations or entitlements to interest. Consider what contracts and which counterparties this is relevant to and seek advice on what might need to be done.