Unraveling the Perils: Exploring Stress and Amplification Risks in UK Pension Funds and Investment Portfolios

In 2022, the period of stress in UK pension funds started with concerns about the UK fiscal outlook prompting a sharp rise in gilt yields, which led to large mark-to-market losses on the fixed-income portfolio of defined-benefit pension funds. This caused margin and collateral calls that pension and liability-driven investment funds had to meet through the sale of gilt securities, pushing gilt prices even lower. The Bank of England was forced to announce temporary and targeted purchases of long-dated gilts and index-linked gilts to stabilise prices.

 

The goal of this intervention was to allow liability-driven investment funds to rebalance without amplifying the initial shock. This episodeshows that, even though pension funds and insurance companies are not really exposed to maturity transformation risks (like other NBFIs are), they are still at risk of being caught in a death spiral. Furthermore, other NBFIs would be exposed to the risk of investors withdrawing which would further amplify this risk.

Additionally, exposure to a concentrated portfolio of assets combined with liquidity shocks can amplify stress events. For example, redemptions can force investment funds to sell assets, depressing prices and leading to further sales by other market participants with similar portfolio holdings, thus, amplifying the initial shock. Unfortunately, over the last two years, investment fund portfolios have become increasingly similar, increasing the threat of correlated liquidity shocks. This is even more important as NBFIs have also grown in size.

 

Increasing similarity in NBFI portfolios' asset class since 2020

IMF asset class similarity index reached 0.3 points in 2022

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