The quest for yield in the face of low interest rates and a low yield climate has driven some UK pension plans to look for more speculative and illiquid assets to gain their expected return.
The Pensions Regulator (TPR), the UK watchdog for work-based pension plans, has published a report on leverage and liquidity to better understand the potential risks associated with defined benefit pensions and to help inform the Financial Stability Report of the Bank of England.
The Bank of England's Financial Policy Committee (FPC) presented its assessment of leverage risks within the non-bank financial system in its 2018 Financial Stability Report. It said non-bank financial institutions ' use of the leverage could support the functioning of the financial market. However, it also stated that "it can also expose non-banks to greater losses and sudden liquidity demands”
The FPC said that the Bank of England would work with TPR to enhance the monitoring of possible systemic risks that might arise.
Preliminary analysis by the regulator shows that many plans are well-diversified and are aware of the risks that leverage and liquidity can pose. But it also shows that some plans are pursuing riskier investment strategies in search of extra returns, which TPR said in the event of adverse economic shocks could be damaging.
We believe that some of these strategies introduce additional risks which may not be adequately rewarded, and which may amplify market impacts in the event of adverse shocks.
We also believe that some of the longer term illiquid investments may not adequately allow for the risks that climate change may introduce.
Fred Berry, TPR’s head of investment consultancy, said in a release.
One of the report's key findings was that the pension plans surveyed held £ 244 billion in pooled investment holdings, 33% in equities and 22% in credit. Bonds made up 60 per cent of all plan assets, half of which were government bonds linked to inflation.
Interest rate swaps were held by 62 per cent of the plans, accounting for 43 per cent of all leveraged investments, and swaps represented 66 per cent of outstanding derivative contracts. The report also found that 45 percent of all plans had increased their leverage utilisation over the last five years, and 23 percent had increased their leverage utilisation over the past 12 months.
The survey covered 137 of the UK's largest 400 defined benefit pension plans, which had nearly £ 700 billion of assets combined.
We believe that some of the survey data shows a potential for concentrations of risk within individual plans
We will analyze the survey responses in more detail and consider how we can use the findings to help trustees to improve their risk management practices further.
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