Fitch Ratings has said that the need for pension funds to put up large amounts of extra collateral due to tumbling gilt prices will lead more UK defined-benefit pension funds to favour pension risk transfer deals with life insurers over liability-driven investment (LDI) arrangements with asset managers.
In its report, Fitch suggests that the UK’s ‘mini-Budget’ issued on the 23rd of September led to the rapid drop in gilt prices, which in turn caused a sharp increase in collateral requirements from many LDI funds as derivative contracts protecting against lower interest rates moved significantly “out of the money.”
Fitch notes, “The scale of the extra collateral requirements triggered a sell-off of gilts as pension funds scrambled to find the necessary cash.”
“This exacerbated the fall in gilt prices and led to the Bank of England intervening to stabilise the market.”
“The crisis highlighted the risks of LDI funds that make substantial use of derivatives, and we believe pension schemes’ appetite for LDI solutions will be greatly reduced as a result.”
Additionally, Fitch expects pension schemes to be warier of untested non-insurance pension consolidators due to heightened risk aversion. With LDI funds falling out of favour, it also observes that pension schemes will become more interested in pension buy-in and buy-out deals with life insurers.
Pension de-risking through insurers involves less risk than LDI funds, says Fitch, noting that pension funds or pensioners are still exposed to the risk of insurance companies failing, but insurers are subject to substantial capital requirements, including a requirement to match long-duration cashflows with suitable assets.
Fitch affirms that insurers also hold strong liquidity buffers, which are stress-tested for various scenarios, including recent market events.
The ratings agency expects insurers’ liquidity positions to have comfortably withstood the recent gilt market volatility, despite the investor concerns implied by the companies’ share price movements.