Britain’s pensions industry is presenting a new challenge to the country’s government bond market, which is valued at £2 trillion. The sector, Europe’s largest, is expected to step back from purchasing UK debt, known as gilts, just as the Bank of England (BoE) reduces its own holdings. This reduction, combined with high levels of debt issuance, is adding pressure to British borrowing costs.
Pension funds, who are major buyers of gilts, are currently benefiting from high interest rates. They are better funded than they have been in years, making them more capable of meeting future payouts. To make the most of this strength, pension funds are rushing to purchase bulk annuity policies from insurers. This involves transferring pension liabilities and some assets to insurers, reducing uncertainty in their balance sheets.
Insurers, however, hold significantly less government debt than pension funds and prefer higher-return assets such as corporate debt. As a result, they are expected to sell some of the gilts they receive. This potential reduction in demand is concerning, as pension funds and insurers hold a quarter of the outstanding gilts.
The deals between pension funds and insurers, such as buy-outs and buy-ins, reached a record £20.2 billion in the first half of 2023, according to pension consultants Lane Clark & Peacock. They estimate that these deals could surge to £45 billion this year, and potentially reach £600 billion over the next decade. For every buyout, there is a net sale of gilts, which could have a significant impact on the market.
While pension funds hold around 50% of their assets in gilts, insurers only hold 15%, according to estimates from Van Lanschot Kempen Investment Management. The company expects insurers to sell £100 to £150 billion of the gilts they acquire from pension funds in the coming years. This could lead to a significant outflow from the gilt market.
The timing of a potential step back from pension funds couldn’t be worse, considering Britain’s high funding needs and weakening economy. The country is set to sell a record £240 billion of debt this year, and private buyers will need to step in to meet these demands for years to come. Additionally, the BoE, the largest creditor holding 30% of the country’s debt, has decided to reduce its holdings faster.
Simultaneous sales of pension fund and BoE gilt holdings are a “key concern” for Britain’s debt management agency, according to Craig Inches, head of rates and cash at Royal London Asset Management. Investors are already seeing signs of this reduced demand leading to higher borrowing costs, such as the recent rise in longer-dated yields relative to shorter ones.
Despite the potential impact of pension fund transfers on gilt demand, Britain’s debt agency expects pension funds and insurers to remain a crucial investor base, showing strong demand for longer-dated gilts. The agency believes that maintaining a diversified investor base will prevent a reduction in demand from impeding funding ability and market liquidity.
The Bank of England declined to comment on the matter.
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