Written evidence from the Association of British Insurers (ABI) LDI0039

Executive summary

The unprecedented recent volatility in the gilt markets meant some DB pensions schemes who had adopted particular investment strategies were facing liquidity issues in trying to find collateral for margin calls. In the early stages before the Bank’s intervention, there was also a risk of contagion to other assets as schemes were trying to raise liquidity. Index-linked gilts were also not included in the initial intervention from the Bank, raising concerns about the liquidity in that market, although this was subsequently rectified.

The members of DB pension schemes were never in danger of losing their benefits, as this was a liquidity issue which could only become a solvency issue if there was no backstop. Moreover, DB pension schemes are supported by their sponsoring employer and protected by the Pension Protection Fund. Therefore, the initial coverage of the issue was unhelpful in causing alarm for pension savers.

Insurers were not affected in the same way and to the same extent as DB pensions funds. That is thanks to insurers using lower levels of leverage and less mechanical arrangements such as pooled fund structures. It is also thanks to Solvency II regulations that insurers were more protected from the volatility in the gilts market. That is because of the strict governance and risk management requirements under Solvency II. This includes the need to have liquidity risk and capital management policies, and own risk and solvency assessments (ORSA) which include scenario analysis of extreme market stresses (incorporating both forward looking and reverse stresses), all contributing to ensuring an insurer’s safety and soundness even in stressed market conditions. These elements of Solvency II would not be diluted by the Solvency II reform calls we have made which will result primarily in a fit for purpose prudential regulatory regime but also unlock capital to invest in productive assets, including infrastructure.

When it comes to savers in Defined Contribution schemes, savers would have seen an effect from the recent volatility if they were invested in gilts, especially those who crystalised their losses.

Question 1: The impact on DB schemes of the rise in gilt yields in late September and early October.

1.       Despite the immediate liquidity pressures that the hike in gilt yields put on DB schemes, their funding position is likely to have improved, in some cases materially, if they managed to keep much of their hedging. LCP estimates that nearly one in five of the around 5,000 DB schemes in the UK are now fully funded against the buyout cost and the average projected period to reach full funding on buyout has also reduced by over 5 years.

Question 2: The impact on pension savers, whether in DB or defined contribution pension arrangements.

2.       DC pension savers invested with a significant proportion of their investments in gilts are likely to have seen their pension pots losing value. Providers often move savers into bonds progressively in the years running up to retirement in order to stabilize their income even if markets are volatile.

3.       The degree to which they do so depends on the design of the default fund or the intentions of consumers. For instance, if they want to (or are expected to) buy an annuity, the provider would move them into gilts to match more closely the assets and liabilities of an annuity provider. Guidance on default funds is rightly not prescriptive, and default strategies vary across providers and schemes. As intentions differ depending on each consumer, the investment strategy needs to match in order to lead to the best possible outcome. The ability to access pensions in any way from age 55 means that people can easily change their minds and find their investment mismatched for their intentions. For those in drawdown, FCA’s investment pathways address such mismatches, to the extent intentions are maintained, and providers check in regularly on customers’ intention and behaviours.

4.       Gilts are seen as safe, non-volatile assets, so those approaching or already in retirement are likely to have been significantly invested in gilts. With equities not performing well either, those approaching retirement are likely to have seen losses and may have to reconsider their aimed retirement age.

5.       However, despite the gilt market volatility, the prospective income from gilts was relatively stable, with the returns on gilts increasing. Since annuity rates reflect long-term interest rates, they have also reached higher levels than they have been for some years.

6.       During this heightened period of stress in September - October, we also saw confusion amongst stakeholders and anecdotally amongst consumers (e.g. misunderstanding that ‘pension schemes were going bust’ or ‘had to be bailed out’ and lack of clarity that the investment strategies were concerning DB schemes.) We have not heard any evidence that this influenced people’s decisions during this period. However, some of our member providers reported a spike in client calls and, as a result, sent explainer communications,  refreshed their available information on volatility and made webinars for consumers and advisors.  This episode highlighted the importance of knowing what kind of pensions one has, be that DC or DB, their rights, the fact they are invested, the benefits of this and the risks they are exposed to.

7.       The ABI and PLSA’s three-year Pension Attention aims to boost people’s understanding and engagement with their pensions, and in time hopefully addressing some of the confusion and unwarranted worries that people may have about their pensions that could in times of stress expose them to the risk of taking rushed unwise decisions. Other mechanisms which this Committee has supported, including pensions dashboards and access to advice and guidance,  can all help to improve engagement and understanding.

Question 3: Given its responsibility for regulating workplace pensions, whether the Pensions Regulator has taken the right approach to regulating the use of LDI and had the right monitoring arrangements.

Question 4: Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?

8.       We have no comments on these questions.

Question 5: Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?

9.       To ensure that LDI is fit for purpose, the size of buffers has to be appropriate for the level of exposure and the maximum amount of leverage may need to be regulated. Regulators should ensure they have an overarching plan in a large collateral call scenario. 

Question 6: Does the experience suggest other policy or governance changes needed, for example to DB funding rules?

10.    There is a balance to be struck between financial safety which carries the risk of sponsor dependency and efficient investment which carries with it investment risk and exposure to systemic risk.

11.    We are not in a position to comment on necessary changes, but agree that joint and cross border regulatory framework and supervision is needed.

12.    It may be worth exploring the idea of allowing schemes to post gilts as collateral in their derivativities positions. This would put less pressure on the gilt market hindering an asset price spiral.

November 2022