UK Pension Deficit Crisis: Defined Benefit Schemes Face Asset Liability Mismatch
The United Kingdom’s defined benefit pension landscape remains in a state of complex transition following the liability-driven investment crisis of 2022 and the subsequent period of higher interest rates that has simultaneously improved aggregate funding positions while exposing structural vulnerabilities in schemes that had not adequately repositioned their investment strategies following the market turmoil. The Pensions Regulator has intensified its scrutiny of scheme trustees and their investment advisers in response to the continuing complexity of the landscape.
Higher interest rates are, in theory, beneficial for defined benefit pension funding because they reduce the present value of future pension liabilities — the lower the discount rate applied to future payments, the smaller the capital that needs to be held today to meet them. The sharp increase in gilt yields since 2022 has therefore dramatically improved the aggregate funding position of the UK’s defined benefit sector, with many schemes moving from deficit to surplus over a relatively short period.
However, the route to this improved position was deeply uncomfortable for schemes that had adopted liability-driven investment strategies involving leveraged gilt positions. When gilt yields spiked sharply in the aftermath of the mini-budget of September 2022, these schemes faced margin calls that forced rushed asset sales, creating a near-systemic crisis that required Bank of England intervention. Many schemes that survived the crisis did so by significantly unwinding their LDI exposures, leaving them with different asset-liability profiles that may not be optimally positioned for the long term.
The Regulator’s concern is that some schemes retain complex derivative positions that create risk concentrations not adequately understood by their trustees, and that the improved funding positions are masking underlying structural fragility that would be exposed by another period of acute market stress.
