The search for yield amid low interest rates and a low return environment has led some UK pension plans to seek out riskier and more illiquid investments to earn their targeted return.
The Pensions Regulator (TPR), the UK’s watchdog for work-based pension plans, has published a report on leverage and liquidity to better understand the potential risks for defined benefit pensions, and to help inform the Bank of England’s Financial Stability Report.
In its 2018 Financial Stability Report, the Bank of England’s Financial Policy Committee (FPC) presented its assessment of risks from leverage in the non-bank financial system. It said that the use of leverage by non-bank financial institutions could support financial market functioning. It also said, however, that “it can also expose non-banks to greater losses and sudden demands for liquidity, which can give rise to financial stability risks.”
The FPC said that the Bank of England would work with TPR to enhance the monitoring of possible systemic risks that might arise.
The regulator’s preliminary analysis shows many plans are well-diversified and aware of the risks that can come from leverage and liquidity. But it also shows some plans are pursuing riskier investment strategies in search of extra returns, which TPR said could be damaging in the event of adverse economic shocks.
“We believe that some of these strategies introduce additional risks which may not be adequately rewarded, and which may amplify market impacts in the event of adverse shocks,” Fred Berry, TPR’s head of investment consultancy, said in a release. “We also believe that some of the longer term illiquid investments may not adequately allow for the risks that climate change may introduce.”
One of the key finding of the report was that the pension plans surveyed held £244 billion within pooled investment holdings, 33% of which was in equities, and 22% of which was in credit. Bonds accounted for 60% of all plan assets, half of which were inflation-linked government bonds.
Interest rate swaps were held by 62% of plans, and accounted for 43% of all leveraged investments, and swaps accounted for 66% of derivative contracts outstanding. The report also found that 45% of all plans had increased their use of leverage during the last five years, and 23% had increased their use of leverage in the last 12 months.
The survey covered 137 of the UK’s largest 400 defined benefit pension plans, which had combined assets worth nearly £700 billion.
“We believe that some of the survey data shows a potential for concentrations of risk within individual plans,” Berry said. “We will analyze the survey responses in more detail and consider how we can use the findings to help trustees to improve their risk management practices further.”