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IF Insights: Tracking the recovery path of UK pension industry after 2022 ‘LDI Crisis’

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Having a pension fund when the interest rate is high makes it more than a rollicking prospect rather than investing in the stock market in the current financial atmosphere

The United Kingdom possesses Europe’s biggest pensions industry. Exactly one year before, the sector faced a massive volatility called the ‘LDI Crisis’. So how is this segment, which is considered the backbone of the European country’s 2 trillion pound (USD 2.5 trillion) government bond market, doing now?

A Quick Flashback Of 2022

As of September 2023, pension funds are purchasing bulk annuity policies from insurers, to whom they transfer pension liabilities along with assets, thus reducing balance sheet uncertainty.

As of September 2023, Bank of England’s interest rate stands at a record 5.25%. While those having mortgage payments are feeling the heat, older generations and wealthier households are benefiting from higher rates because they are getting more time to accumulate wealth.

“Rate hikes can boost returns on savings and fixed-income assets such as bonds and annuities (which provide a fixed income stream in retirement),” stated The Conversation.

In short, having a pension fund when the interest rate is high makes it more than a rollicking prospect rather than investing in the stock market in the current financial atmosphere. Reduced consumer spending in this inflation period has resulted in companies making less money for shareholders.

While the big asset managers have now turned positive on gilts, lured in by high yields and the confidence about inflation in the European country is easing, market analysts believe that pension funds, who along with insurers hold a quarter of outstanding gilts, may step back from this ‘optimism’, going by the 2022 rout which saw pension funds dumping UK bonds in fire sales to meet collateral calls from Liability-Driven Investment (LDI) funds.

What Happened Back Then?

In 2022, the then-Chancellor of the Exchequer Kwasi Kwarteng outlined unfunded tax cuts among other fiscal proposals. The move saw yields jumping by about 165 basis points immediately. Pension funds with about 1.6 trillion pounds (USD 1.99 trillion) in LDI programs and interest-rate hedges, which use derivatives overlays, suddenly faced the pressure of posting more collateral against their hedging positions.

“Some were forced to let their hedging positions fall. Others found themselves scrambling to sell out of liquid assets — including gilts, thereby exacerbating plummeting prices — and then also rushing to offload illiquid assets in order to raise the cash they suddenly needed. And for some of the pension funds whose LDI positions were leveraged, the problems were even greater,” commented a report from Pension&Investments, while recollecting the period.

“On September 28, the Bank of England stepped in to backstop the gilt market. It stood ready to buy up to 65 billion pounds in gilts over about two weeks. Gilt markets calmed, pension funds rethought their collateral buffers and regulators reinforced the needs for these enhanced measures, stipulating that LDI programs should be able to absorb a minimum 250 basis points shock in the gilt markets,” it added further.

LDIs, which are employed in final salary pension plans and other fixed-income schemes (in order to cover liabilities by acquiring assets and generating returns), use long-dated British government bonds as collateral to raise cash.

The whole crisis pushed down LDI prices and sent the value of their assets below that of their liabilities, thus bringing insolvency worry into play.

Have Things Changed?

However, the sector is showing signs of recovery as the deals between pension funds and insurers reached a record 20.2 billion pounds in the first half of 2023, as per an estimate from pension consultants Lane Clark & Peacock, which expects a surge to 45 billion pounds this year and as much as 600 billion pounds over the next decade.

As per the Van Lanschot Kempen Investment Management estimates, while pension funds currently hold roughly 50% of their assets in gilts, insurers only hold 15%. The study expects insurers to sell 100 to 150 billion pounds of the gilts they take over from pension funds in the coming years.

The pension fund sector is selling 240 billion pounds of debt so far in 2023, a record figure. The amount private buyers need to buy will remain elevated for years as interest payments rise and the BoE, its biggest creditor holding 30% of its debt, decided in September to reduce its holdings faster, by 100 billion pounds over 2024.

The UK Debt Management Office told the media that it was aware of the pensions’ transfers and their potential to impact gilt demand, but expected pension funds and insurers to remain a “very important” investor base, while continuing to show strong demand for longer-dated gilts.

The Hunt Plan

The UK chancellor Jeremy Hunt is now attempting reforms which will make fund managers invest more boldly, thereby expanding the pensions’ pots at a never-seen-before scale.

“These plans would mark a major change for pension funds which traditionally keep most of their money in assets viewed as safe and long-term sources of income and capital growth. This steers them towards shares (equities) and bonds (traded debt) issued by large established companies, and government bonds, considered the safest form of debt,” commented a Conversation article, while discussing the Rishi Sunak government’s reform plans.

According to the Sunak government’s calculations, the roadmap may ensure an extra 50 billion pounds of investment into innovative firms by 2030, thus giving a 12% (1,000 pounds a year) boost to the pension of an 18-year-old who enrols in a pension fund in 2023.

As indicated by the UK Treasury, doubling public sector pension funds’ holdings of private equity to 10% of their portfolio would unlock another 25 billion pounds worth of investment by 2030.

While the Bank of England welcomed Hunt’s plans, it needs to cooperate with the roadmap by relaxing interest rates further, which, given the current inflation scenario, looks unlikely.

The Road Ahead

Apart from eating into household wealth, curbing consumer spending and further reducing the incentive for business investments, the 5.25% BoE interest rate is forcing investors to lock the money safely in bank deposits/government bonds.

Add the Brexit, which has hampered the channelling of funds into British companies. Initial Public Offerings (IFOs) in the UK too dried up in 2022 after a 2021 revival.

Hunt’s plan is simple, to simplify rules for new company listings, and make London the next global stock hub. Making pension fund managers invest more boldly is just one part of the master plan.

The 2022 gilt crisis has definitely exposed structural flaws in the UK pension system and everyone from the Bank of England to Member of Parliaments are asking for an overall system reform, a demand which the Rishi Sunak government must pay attention towards, as its plan of making the sector bold will depend upon the latter’s solidity against market headwinds.

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