Gilts crisis undermines efforts to use pension funds for economic growth

The liquidity crisis engulfing gilts markets has jeopardized a government initiative to use pension funds to spur economic growth and the transition to a low-carbon economy, executives have warned.

As part of the government’s post-Brexit vision for the City of London, the UK regulator last year approved a new type of fund that allows investment in long-term, illiquid assets, including venture capital, private equity, private debt, real estate and infrastructure.

The “Long-Term Asset Fund” or LTAF structure is intended to give companies and infrastructure projects better access to capital from investors such as pension funds with a longer-term investment horizon. The plan is part of a long-standing government aim to use the resources of the UK economy more effectively, an aim made even more important by Prime Minister Liz Truss’ emphasis on growth.

But a flight in UK government bonds, sparked by unfunded tax cuts in Chancellor Kwasi Kwarteng’s ‘mini’ budget on September 23, has pushed the UK pension industry into a vicious cycle of forced asset sales to raise cash.

“Pension funds have proportionally more exposure to illiquid assets, affecting their willingness and ability to make new commitments,” said Kerrin Rosenberg, chief executive officer of Cardano, a consulting firm and investment manager. “The pension fund industry’s ability to be a buyer of illiquid assets has taken a hit.”

Pension funds investing in liability-based strategies driven by the $1.45 trillion defined benefit pension industry.

It could cut off a potential source of funding for long-term investment funds, according to Peter Harrison, chief executive of FTSE 100-listed wealth manager Schroders, which is launching them in the UK and Europe. “UK DB funds will be reluctant to buy private wealth for a long time to come,” he said.

Former Pensions Secretary Steve Webb, a partner at consultancy Lane Clark & ​​Peacock, said the government’s LTAF plan clashed with its quest for schemes to ensure pensions can afford to pay retirees.

“One arm of government is asking systems to back out of risky return-seeking investments and the other arm of government is asking them to get involved,” he said. “A more nuanced conversation needs to be had about the barriers to investing in illiquid companies [assets]and honestly we have more barriers now.”

LDI hedging strategies helped the funds match assets and liabilities during the long period of low interest rates, but required huge safety injections when Kwarteng’s financial plan caused gilt yields to soar.

The sell-off in the gilts market means that illiquid assets now account for a higher proportion of the overall asset allocation of defined benefit plans.

Webb said there are some pensions for which investing in illiquid assets makes sense, such as open-ended schemes meant to run for decades or municipal schemes with a long-term horizon. “But most pensions don’t look like that,” he added.

When DB systems are closed to new members, they typically move out of “growth” assets, including illiquid ones, and toward gilts to reflect their future liabilities.

“If you need more collateral now and more cash going forward, that will speed that up,” Webb said. DB systems “were reticent [to invest in illiquid assets] and will be even more hesitant after what has happened recently.”

Government officials said the turmoil in the gilts market would not hamper efforts to funnel more money into long-term mutual funds, which are aimed more at defined contribution schemes – where income depends on market returns – than the defined benefit pension market. A survey commissioned by the Department for Works and Pensions found that two-thirds of DC schemes do not invest in illiquid assets, while the remaining third invest less than 7 percent.

Other executives said alternative companies’ fundraising plans could also be hit by the fallout from the pension crisis.

“There will be a pause in the push into private markets, which has gained momentum over the past decade,” said the head of UK trust management at a major wealth manager.

“This will impact alternative players who rely on UK pension funds to raise wealth.” The appetite for new exposure to strategies like inflation-linked assets, real estate and renewable energy “is getting really challenging,” he added.

Additional reporting by Jim Pickard in London