What happens as DB pensions unwind the ‘frightening’ amount of gilts they own?
Steve Hodder, a partner at LCP, said the proportion of the gilt market owned by defined benefit schemes was “quite frightening” - particularly given the number of DB schemes closing and the large amount of buy-out activity (FT montage/Bloomberg)
While we were looking into the state of UK equities recently, Steve Hodder, a partner at LCP, brought a slightly concerning statistic to our attention:
“Defined benefit schemes own a vast proportion of the gilt market. So it's quite frightening. When you look at the ownership of the gilt market, it's systematically owned, effectively, by DB pension schemes and the Bank of England.”
Hodder said that while on paper pension funds owned about 25 per cent of the 2022 gilt market, the number was actually closer to 37 per cent.
More recent data from 2024 estimates UK pension funds and insurance companies hold $602bn worth of gilts, equating to 22.3 per cent of the entire market. Coupled with the Bank of England, both groups account for almost half of the entire gilt market at 45.7 per cent.
Two reasons as to why this should keep us up at night: first, a concentrated buy-side market surely presents risks when there are shocks, as seen in 2022 under Liz Truss’s short-lived stint as UK prime minister.
Secondly, as DB schemes become fully-funded what happens when a stable customer base slowly but surely dries up?
Matt Tickle, chief investment officer at Barnett Waddingham, says: “UK DB PLC has pretty much bought all the gilts it needs to buy to meet those liabilities. It's not 100 per cent and there are some schemes that will still be buying at the margins, but fundamentally they're there.”
The Office for Budget Responsibility shares these concerns:
“The gilt holdings of pension funds will decline in the coming years as most private sector DB pension schemes are closed to new members and will eventually wind down. The rise of DC schemes in their place is unlikely to make up for the resulting decline in gilt demand. DC schemes tend to have portfolios dominated by equities. They therefore hold a smaller share of their assets in gilts compared to DB schemes, particularly given the fall in annuitisation rates among DC pensioners over the last decade.”
The OBR estimates the value of gilts held by DB pension funds is closer to $803bn, with most of this in closed schemes. And the OBR raises another issue: the boom in buy-outs.
It said: “Annuity providers and insurance companies have a much lower share of assets in gilts than private sector DB schemes therefore buy-out transactions tend to reduce demand for gilts.”
And as everyone knows, the past few years have seen a bumper amount of DB buy-out: last year saw 299 DB buy-ins valued at $63bn completed.
This was the largest amount in a single year, according to Hymans Robertson.
The pension to insurer transfer
The OBR suggests that of the $351bn in assets held by insurers and annuity providers in 2024, only 18 per cent (or $62bn) was in gilts.
Phoenix Group’s head of capital markets Nuwan Goonetilleke says when an insurer does a buy-in of a DB scheme, it would hold a portfolio of high-quality fixed income assets usually split half in public fixed assets such as gilts and public credit, and half in private fixed assets such as infrastructure and real estate.
Ultimately this would mean fewer gilts.
“While insurers hold a smaller proportion of gilts compared to closed DB schemes, allocations can vary with market conditions,” Goonetilleke adds. Phoenix’s gilt exposure has averaged around 10 per cent historically but “tighter credit spreads have made gilts more attractive”.
Tickle says: “The spreads on corporate credit relative to government bonds are so tight that it doesn't really pay insurers to take that risk”.
He thinks there will be less net effect on the gilt market this year because the value of buy-in transactions is expected to be lower, coupled with insurers retaining gilts and steadying demand.
So what happens next?
The OBR’s central projection is that the pension sector’s gilt holdings will fall from 29.5 per cent of GDP in 2024-25 to 10.9 per cent of GDP in 2073-74.
To make up for the decline of pension funds buying gilts, the OBR says it needs to bring in more gilt buyers “attracting these marginal investors [...] is likely to require somewhat higher yields”.
Estimating that it could increase the interest rate on UK government debt by 0.8 percentage points, at current prices and today’s level where debt is close to 100 per cent of GDP it would mean an increase in annual debt interest rate costs of $29bn.
By these estimates it would be a 20.6 per cent increase in gilt interest repayments.
For those being kept up at night by this issue (probably not Rachel Reeves, for once, since she will be nearly 100 years old in 2073) Tickle says the UK’s Debt Management Office is issuing shorter debt than it has done previously because of this issue.
“There's far more focus on the extent of looking at the shorter part of the market,” he says.
The benefits of issuing shorter term debt is that it is cheaper. But it poses a risk when refinancing.
“I think what we'll see is that the structure of that gilt market will change over time and that the duration of the gilt market will come down because of that change in demand. If that happens over the next 10-20 years, then I don't see any issues whatsoever,” Tickle says.
A white paper from the Institute of Fiscal Studies, a UK think tank, forecasts the weighted average maturity of primary gilt supply, which was more than 20 years in 2016-17, will decline to below 10 years in 2025-26.
But Tickle did warn: “The concern is if something goes pop somewhere along the way”.
And as we know, nothing ever goes “pop” in global economies.