Pension funds after the gilts crisis: the big asset allocation rethink


When UK pension funds started to buckle under the turbulence caused by the Truss government’s “mini” Budget in September, senior executives at J Sainsbury were taking no chances.

The supermarket group’s pension fund, which has more than 70,000 members, had weathered the initial market volatility. But the company, fearful of more ructions once the Bank of England stabilisation measures were withdrawn, hurriedly set up a loan facility for £500mn. 

“We decided to put a short-term loan in place should [the pension fund] require it,” said Sainsbury’s chief financial officer Kevin O’Byrne. “If there was a spike [in gilt yields] . . . we didn’t want them to have to do anything irrational like selling assets at the wrong time.”

In the end, the trustees did not need to draw on the cash. Shortly after the loan facility was set up, Britain changed chancellor and the markets stabilised.

But the episode illustrates how wild swings in the gilt markets have taught UK pension funds an important lesson: assets that cannot be quickly converted to cash may deliver higher returns, but in a crisis pension schemes need assets they can sell fast.

Turbulence in the UK gilt market; Yield on 20-year gilt (%)

“There’ll be a new focus on liquidity,” says Andrew Lewis, chief financial officer of FTSE 250 aerospace and defence group Chemring. “I don’t think people really understood the liquidity risk, which is very different from the funding risk.” 

The immediate impact of the gilt market chaos has been to shine a light on liability-driven investing, which has become a widely used strategy over the last two decades among the UK’s 5,200 defined benefit (DB) pension schemes — so called because they promise to pay employees’ pensions at a fixed level. The LDI strategy typically uses derivatives to increase pension funds’ exposure to UK government bonds while offering protection against moves in interest rates and inflation, and freeing up cash to invest in assets that can generate higher returns.

But as the dust settles, there are likely to be important reverberations throughout the rest of the investment sector. The market chaos is accelerating the rethink that was already under way among pension funds about the so-called 60/40 allocation of assets between equities and bonds, which has performed poorly during this year’s sell-off.

And the renewed focus on liquidity could reduce the amount that pension funds seek to allocate to private markets — despite a government push to get them to invest more in infrastructure projects. Market participants anticipate that pension funds will have a reduced appetite for more illiquid holdings, including property and private credit, and some may look to sell their stakes in buyout funds.

“In the aftermath of the LDI crisis the strategic asset allocation of DB schemes will change materially,” says Michael Eakins, chief investment officer at Phoenix Group, one of the UK’s largest savings and retirement businesses. “They will be less invested in private markets and more in liquid markets like bonds and gilts.” 

Shoppers purchase groceries at the checkout tills inside a J Sainsbury supermarket
Shoppers at Sainsbury’s. The supermarket group’s pension fund has overcome the market volatility sparked by the ‘mini’ Budget but the LDI crisis left the company fearful of more turmoil © Simon Dawson/Bloomberg

LDI managers — such as BlackRock, Insight Investment and Legal and General Investment Management — are shifting to a more conservative approach. They are reducing leverage and demanding that pension schemes put up more collateral to keep the same hedges in place, which means that there is less spare cash to invest in other assets.

“The issue with private assets is that, in times of stress, they can’t be mobilised,” says Vincent Mortier, chief investment officer at Amundi, Europe’s largest asset manager. “There will be some new thinking about liquidity management in order to avoid being trapped and having to sell things in a desperate way.”

While the recent LDI crisis is concentrated in the UK market, there are wider ramifications.

“The huge takeaway globally is liquidity, liquidity, liquidity and making sure you can meet all these margin calls,” says Peter van Dooijeweert, head of multi-asset solutions at Man Group. “Everyone is taking a pause here to say look, if I can see a major developed bond market move 15-20 per cent in a day in the 20-year duration bucket, I need to make sure that my pension fund is OK for that.”

Shifting allocation

Asset allocation by the UK’s DB schemes has shifted dramatically over the past 15 years. These funds collectively have more than 10mn members and £1.5tn assets under management.

At the end of 2021, they were 72 per cent allocated to bonds, 19 per cent to equities and the rest to other investments such as property and hedge funds, according to the Pension Protection Fund, the lifeboat scheme for the sector. This contrasts with 2006, when they were 62 per cent invested in equities and 28 per cent in bonds.

This trend reflects how regulation and politics have pushed DB pension funds out of equities to invest more heavily in bonds, which are considered “safe” assets that reduce the risk to the portfolio and sponsoring employer.

An important part of that approach has been the growing use of LDI by pension funds. But when gilt prices plummeted after the “mini” Budget announcement of unfunded tax cuts, counterparties made urgent demands for more cash as collateral to keep the hedging arrangements in place and the strategy came unstuck.

Pension funds became forced sellers of assets to meet these collateral calls. They dumped gilts, causing prices to fall further, and also slashed their holdings in the most liquid securities, such as corporate bonds and equities.

“There’s been more activity in pension schemes in the past month than there has been in the past five years,” says Alex Millar, head of UK distribution at $1.3tn asset manager Invesco.

Sarah Breeden, a member of the Bank of England’s Financial Policy Committee, said on Monday that LDI funds sold £30bn of gilts and raised over £40bn in funds during the period of market turmoil. “The root cause is simple,” she said. “Poorly managed leverage.”

But the irony for DB schemes is that while the sharp swings in the gilt markets wreaked havoc on liquidity, their overall funding positions have actually improved dramatically. This is because the steep rise in interest rates has shrunk liabilities faster than asset values have declined, as higher yields reduce outstanding obligations to retirees.

It means that schemes are now much closer to what is known as “buyout”, when a fund pays an insurance company to take over the pension payout promises and the corporate sponsor offloads the pension fund risk. This has implications for their asset allocation.

Employees work on a section of a wing on the Airbus A350 production line
A section of a wing on the Airbus A350 production line. Some schemes, including the pension fund for Airbus employees, are planning to sell illiquid assets to better position themselves for buyout © Matthew Lloyd/Bloomberg

“As pension funds get closer to buyout they will want to have less market risk, and higher capital buffers will be required for their LDI strategies,” says Peter Harrison, chief executive at FTSE 100 asset manager Schroders. Both of these reasons “will force DB pension funds to be sellers of growth assets”.

The momentum is likely to accelerate as schemes offload illiquid holdings, such as private equity and infrastructure, to better position themselves for buyout. A trustee at the pension scheme of Airbus, the world’s largest aircraft maker, says it plans to reduce risk and add to its LDI hedge as it moves closer to buyout. It will gradually reduce its property and infrastructure portfolios.

The UK DB market is now on a £155bn surplus compared to a £600bn deficit a year ago, while liabilities have shrunk to £1.2tn from £2.4tn, according to professional services firm PwC. JPMorgan has forecast that £600bn of DB pensions could be bought out over the next decade, more than double the rate of the past 10 years.

Harrison says that pension funds will become “more circumspect” about investments in other assets. “The future fundraising for parts of private equity is going to be much tougher,” he says.

The end of the Great Moderation

Even before the pensions drama in the UK, institutional investors were already revisiting many of their core assumptions.

“This is an exceptional year for asset allocation,” says Stephen Cohen, head of Europe, Middle East and Africa at BlackRock, the asset management group. “It’s the end of the Great Moderation,” he adds, referring to the long period of steady growth, falling interest rates and lots of liquidity in the markets. “Conversations with investors are around high inflation, more volatility and rising interest rates.”

In addition to these market forces, there is the war in Ukraine, global energy and food crises, supply chain disruption, and geopolitical tensions between the US and China.

Historically stocks and bonds were seldom correlated for long periods, but this year they have fallen in tandem, leaving investors questioning how to balance risks in their portfolios.

“The difficulty you have as a multi-asset investor this year is that it’s been virtually impossible to find diversification,” says Jon Cunliffe, managing director of investments at pensions provider B&CE.

Fiona Frick, chief executive officer of Unigestion
Fiona Frick, chief executive of Unigestion © Bloomberg

“There is nowhere to hide for investors,” says Fiona Frick, chief executive of Swiss asset manager Unigestion. “Our clients are in freeze mode at the moment.” 

The positive correlation between equities and bonds has undermined the 60/40 balanced…



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2022-11-07 21:01:41

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