In 2022 the headwinds facing asset managers reliant on the UK’s £3trn occupational pension schemes became even more extreme. The war in Ukraine and Liz Truss’ actions last September brought about a once in a generation change to financial markets.
(I’ve used a photo of an iceberg lettuce because, well, illustrating pension stories is hard and it’s my nod to the Daily Star’s hilarious live stream to see which lasted longer – an iceberg lettuce or Liz Truss, without breaching their copyright. ICYMI the 60p iceberg won.)
Like a phoenix rising from the ashes, inflation not only roared back to life but remained higher and stickier than most predicted.
Interest rates have risen rapidly with the Bank of England deciding to pause rate rises this week after increasing them 14 consecutive times. The higher cost of borrowing pushed up the collateral payments schemes need to make to maintain their interest-rate hedges.
Finding the cash to make these payments was a challenge throughout the first half of last year but it was manageable. The Kwasi Kwarteng mini-budget in September 2022 turbo-charged this into a disaster with the Bank of England having to intervene to prevent it becoming systemic crisis.
As the dust settled, two things became clear. Firstly, higher interest rates meant that liability valuations had tumbled improving funding. Many closed DB pension schemes now find themselves much closer to their goal of either buy-out or self-sufficiency.
Secondly, many schemes found themselves owning wonky portfolios. Listed assets had been sold down to fund collateral payments.
But as allocations to alternatives like private debt and infrastructure were too illiquid to sell, these holdings had been left intact. Falling asset valuations meant they made up too higher a proportion of the asset portfolio. For example, they might now make up 10% instead of 5% of the total assets.
This had two impacts for asset managers. Virtually overnight further allocations to private assets from closed defined benefit schemes were turned off as further money would not be added to these assets until their weighting in the portfolio returns to the strategic goal.
In addition, DB pension schemes who are suddenly in reach of their buy-out ambitions are loath to reduce this strong position and, if anything, have become even more risk adverse.
Asset managers reliant to closed private DB schemes as a source of assets for their alternative funds now must find another market. Many have redoubled their efforts to sell to the LGPS but as this only has assets of £500bn, there is capital less to go round.
In theory, workplace DC could provide a stable source of income – alternative assets as well as equities can both be used to help today’s workers accumulate wealth ahead of retirement.
But cost pressures mean only passive equities are palatable to DC and concerns over the higher costs of alternatives assets mean this market is underdeveloped for assets such as private debt and equity.
The events of last year mean many asset managers have seen institutional demand for their products fall off a cliff.
Legacy DB schemes whose appetite for their alternative products has been snapped out over night while the new source of assets, DC workplace schemes, is too underdeveloped to provide a useful replacement.
If things were not hard enough, they have been even tougher over the course of this year. The next blog post will tackle these challenges.