Portrait of Francis Richard Pereira

The gilt market spiral in September, which created a material risk to UK financial stability, has brought defined benefit pension schemes under greater regulatory scrutiny. By Francis Richard Pereira.

In 2023, UK defined benefit (DB) pension schemes will have to navigate significant regulatory changes around funding and investment strategies; proposals to improve liability-driven investment (LDI); and an evolving investment landscape.

The dysfunction in the gilt market following delivery of the Treasury’s growth plan in September 2022, widely known as the ‘mini-Budget’, created a material risk to UK financial stability. The market turmoil impacted DB schemes with leveraged LDI strategies.

To prevent a self-reinforcing ‘fire sale’ spiral in the systematically important gilt market, the Bank of England (BoE) intervened to temporarily purchase gilts and subsequently launched the Temporary Expanded Collateral Repo Facility to help banks ease liquidity pressures. The BoE’s Asset Purchase Facility (APF) financial stability gilt portfolio purchased £19.3bn in nominal and index-linked gilts. By December 28, 2022, these holdings had been unwound in an orderly way to £5.35bn.

Consequently, DB schemes — particularly those using pooled leveraged LDI strategies — have come under increased scrutiny. Their activity as non-bank financial institutions in market-based finance risked amplifying gilt market dislocation, threatening UK financial stability.

Asset allocation trends

UK DB schemes hold around £1.4tn in assets. There has been a fundamental reorientation in scheme asset allocations between 2006 and 2022. Pension Protection Fund (PPF) Purple Book data shows that overall equity allocations decreased from 61.1% to 19.5%, and bond allocations increased from 28.3% to 71.6%. Allocation is split between government fixed-interest (22%), corporate fixed-interest (30.2%) and index-linked bonds (47.8%).

Most DB schemes are now closed to new benefit accrual (51%) and new members (38%). Broadly, as scheme maturity increases, funding positions improve and allocations to equity fall. In 2022, rising UK government bond yields improved overall funding ratios. The PPF 7800 index funding ratios improved from 107.7% to 133.7% between December 31, 2021 and November 30, 2022, based on PPF valuation in accordance with section 179 Pensions Act 2004.

UK financial stability

The September 2022 gilt market dysfunction raised concerns over pension fund LDI strategies — specifically pooled leveraged LDI funds — and their ability to respond to sudden volatility.

Four interlinked areas require further attention.

First, gilt markets rapidly became dysfunctional and illiquid. Markets experienced extraordinary gilt yield movements (price falls) and a loss of confidence. Following the mini-Budget, over a period of three to four days, the UK 30-year nominal gilt yield rose by approximately 160 basis points (bps). The speed and scale of movement was unprecedented.

The BoE’s intervention acted as a circuit breaker, preventing a worsening market spiral of falling gilt prices, thereby preventing a self-reinforcing ‘doom loop’ of gilt sales by leveraged LDI funds causing wider contagion.

Hyman Minsky’s ‘Financial Instability Hypothesis’ offers one view on how financial crises develop and why markets suddenly move from stability to instability, causing a loss of confidence and fall in asset prices. Further research is required to understand gilt market vulnerabilities to address potential risks to future market resilience.

Second, pooled leveraged LDI funds and maintaining adequate liquidity buffers. Leveraged LDI funds’ liquidity buffers were insufficient to enable an orderly ‘system-wide’ rebalancing of LDI strategies following unprecedented gilt yield movements. As market conditions improved, and following interaction with European regulators supervising sterling LDI funds, resilience improved to comply with revised supervisory expectations. Average buffers for gilt yield movement were 300bps to 400bps (November 30, 2022).

In contrast, the most conservative buffers had previously been calibrated to movements of 200bps. Regulators now expect LDI funds to have improved procedures under stressed market conditions. Further scrutiny should be given to improving sector-wide transparency, reporting precisely defined financial leverage metrics and minimum thresholds for liquidity buffers.

Third, pension scheme collateral and liquidity management. Under ‘stressed’ gilt market conditions, some schemes faced operational and governance process challenges on decision-making and timely access to collateral for LDI fund recapitalisation. Interestingly, during the second quarter of 2022, under ‘fragile’ gilt market conditions schemes managed to cope with increased liquidity demands to recapitalise LDI pooled funds.

In 2014/15, some large European pension funds evaluated LDI resilience and leverage following high realised volatility in 30-year euro swap rate. It highlighted the importance of an integrated approach between the structure of LDI programmes; liquidity ladders; stress testing; settlement and operational requirements; illiquid investment; and strategic asset allocation.

Action by regulators to collect and monitor aggregate leveraged LDI data [...] could provide an early warning indicator for signs of systemic weakness

UK policy-makers should extend DB pension scheme derivatives clearing exemption beyond June 2023 to enable continued access to non-cleared markets using non-cash margin, such as gilts. Following the Bank for International Settlements’ review of margining practices, improvements to allow use of high-quality collateral in addition to cash or gilts should be explored to support margin calls.

Fourth, and finally, the risks from systemic concentration. Procyclical behaviour increases the risk of contagion and herding under stressed market conditions. Action by regulators to collect and monitor aggregate leveraged LDI data to enhance macroprudential policy decisions could provide an early warning indicator for signs of systemic weakness. This would complement supervisory stress testing, promote proactive engagement with market participants, and improve transparency of leverage in the financial system and interlinkages with banks.

Navigating a complex landscape

Trustees currently face an evolving economic and investment landscape. The most important factors include:

  • Market impact of quantitative tightening and high government borrowing requirements;
  • Assessing growth and inflation outlook — particularly recession and stagflation scenarios in major economies;
  • Sustainability of high global public and private debt in a rising rates regime and tightening financing conditions;
  • Managing liquidity risks in challenging market liquidity conditions, and the impact on illiquid investment allocations and leveraged LDI strategies;
  • Environmental, social and governance, climate change risks, net-zero transition and biodiversity;
  • Financial stability and risk management, including resilience to herding and concentration risk; and
  • Tail risks — geopolitical events, cyber attacks, policy missteps and supply-side shocks.

Gilt market challenges

In fiscal years 2022 to 2024, net gilt issuance to the market will be the highest in history due to significant supply from public sector net borrowing requirements and absence of BoE quantitative easing (QE).

The Office for Budget Responsibility’s ‘Economic and Fiscal Outlook’ (published November 2022) highlighted the increased UK debt to gross domestic product ratio from 28% to 102% between 2000/01 and 2022/23. This is projected to reach 106.7% in 2023/2024, marking a 64-year peak. UK debt interest spending is forecast to rise significantly due to higher debt, increased inflation-linked debt and higher APF QE-related interest costs.

A fragile gilt market had been observed in the summer of 2022. Debt Management Office (DMO) gilt issuance between April and August 2022 raised around £51bn in cash from investors. At the time, 20-year nominal gilt yield rose from 1.82% to 3.19%. DMO operations are scrutinised by investors and speculators to assess gilt market confidence. In the absence of QE purchases, clearing the record gilt supply may be challenging without gilt yields rising.

Regulatory change

Trustees have an essential role in securing scheme members’ pension benefits. Their expertise ensures appropriate scheme funding, investment strategy, risk management and governance. UK DB pension schemes have approximately 9.6 million members, including 4.1 million pensioners.

A significant development impacting UK DB pensions scheme funding and investment strategy is the expected new DB pension regulations and The Pensions Regulator (TPR) revised DB funding code, planned to be effective from October 2023. The new regime prescribes the ‘statement of strategy’ required to be submitted with the scheme actuarial valuation to TPR.

The forthcoming regulation increases emphasis on assessing the ‘strength of the employer covenant’. The employer’s financial ability to support the scheme is an important consideration in evaluating the feasibility of corporate transactions, mergers and acquisitions, and restructuring. The revised funding code incorporates leveraged LDI, related operational requirements, governance, risk and investment considerations.

TPR’s new single code of practice, expected in 2023, includes additional requirements such as own risk assessment and operating an effective system of governance. This complements the revised DB funding code to ensure trustee approach to managing investment risk is underpinned by effective integrated risk management.

Implementation of the Pension Dashboards Regulations 2022 is expected to start in 2023, initially for large master trusts. Pensions dashboards are likely to become an important part of the digital finance ecosystem, enabling scheme savers to view their pension information in one place.

Improving DB scheme outcomes

The regulatory change presents an opportunity for trustees to reassess scheme strategy. As schemes mature, investment strategies must adapt to the trustees’ journey plan to achieve low dependency on the employer.

Trustee judgement in evaluating strategic options to meet a scheme-specific long-term objective is crucial to securing member benefits. This informs trustee decision-making when selecting the optimal funding and investment strategy for employer agreement.

This year and beyond is expected to deliver transformational change for DB schemes.

Francis Richard Pereira is an investment actuary (Fellow of the Institute and Faculty of Actuaries) and chartered accountant (Fellow of the Institute of Chartered Accountants in England & Wales), with institutional expertise in insurance and pensions solutions, alternative assets and digital finance.


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter