The liquidity crisis engulfing the gilts markets has put at risk a government initiative to use pension funds to drive 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 enables investments 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 designed to give businesses and infrastructure projects greater access to capital from investors such as pension funds that have a longer-term investment horizon. The plan is part of a longstanding government goal to use the resources of the British economy more effectively, a target given still more importance by prime minister Liz Truss’s emphasis on growth.
But a rout in UK government bonds sparked by unfunded tax cuts in chancellor Kwasi Kwarteng’s “mini” Budget on September 23 has pushed the UK’s pension industry into a vicious circle of forced asset sales to raise cash.
“Pension funds have higher proportional exposure to illiquid assets, which affects their willingness and ability to make new commitments,” said Kerrin Rosenberg, chief executive of Cardano, an advisory firm and investment manager. “The capacity of the pension fund industry to be a buyer of illiquid assets has taken a blow.”
Pension funds that invest in liability-driven strategies, which are widely used in the £1.45tn defined-benefit pension industry, are facing a liquidity crunch as they are forced to reduce leverage and increase their collateral buffers.
This could cut off one potential source of funding to long-term asset funds, according to Peter Harrison, chief executive of FTSE 100-listed asset manager Schroders, which is launching them in the UK and Europe. “UK DB funds will be circumspect about buying private assets for a long time,” he said.
Former pensions minister Steve Webb, a partner at consultant Lane Clark & Peacock, said the government’s LTAF plan clashes with its push for schemes to ensure pensions can afford to pay retirees.
“One arm of government is telling schemes to get out of risky return-seeking investment and the other arm of government is telling them to get into it,” he said. “There needs to be a more nuanced conversation about the barriers to investing in illiquid [assets], and frankly, we’ve now got more barriers.”
LDI hedging strategies helped funds match up assets and liabilities during the long period of low interest rates, but required huge injections of collateral when Kwarteng’s fiscal plan sent gilt yields soaring.
The sell-off in the gilts market means illiquid investments now represent a higher proportion of defined-benefit schemes’ overall asset allocation.
Webb said that there are some pensions for whom investing in illiquid assets makes sense, such as open schemes that are set to continue for decades, or local government schemes with a long-term horizon. “But most pensions don’t look like that,” he added.
When DB schemes are closed to new members they typically move out of “growth” assets, including illiquids, and towards gilts, to map their future liabilities.
“If you now need more collateral, more cash, for the future, that’s going to accelerate this,” said Webb. DB schemes “have already been reluctant [to invest in illiquid assets] and will be even more reluctant after what’s happened recently”.
Government officials said the turmoil in the gilts market would not impact efforts to channel more money into long-term asset funds, which are more aimed at defined-contribution schemes — in which income depends on market returns — than at the defined-benefit market. A survey commissioned by the Department for Work and Pensions found that two-thirds of DC schemes do not invest in illiquid assets, while the remaining third invest less than 7 per cent.
Other executives said that alternatives firms’ fundraising plans could also be hit by the fallout from the pensions turmoil.
“There’ll be a pause on the private markets push that has gathered momentum over the past decade,” said the head of UK fiduciary management at a larger asset manager.
“This will have an impact on alternatives players who are dependent on UK pension funds for asset raising.” Appetite for new commitments to strategies such as inflation-linked assets, real estate and renewables “are going to be really challenging”, he added.
Additional reporting by Jim Pickard in London