Derivatives play an important role in the toolbox available to pension funds for hedging risk, enhancing returns and protecting cash flows available to meet obligations to retirees. With the UK gilts crisis almost three years behind us, Bob Currie evaluates steps to boost DB scheme resilience
Pension funds may be heavy users of derivatives, employing contracts within their investment strategies to enhance returns on assets while protecting against volatility and downside risk that could impair their ability to meet their payment obligations to retirees.
Given the scale involved, these risk discussions are important – on a systemic level to prevent threats to financial stability and, at a personal level, for the livelihoods of those who have paid into workplace savings plans.
The value of derivatives for pension funds
The International Swaps and Derivatives Association (ISDA) notes in a recent paper that, in 2023, pension assets represented the equivalent of 198.1% of GDP in Denmark, 147.1% in the Netherlands, 142.5% in the US, 129.9% in Australia and 79.3% in the UK. With this financial scale, hedging decisions carry great economic and societal weight, notes the report (The Value of OTC Derivatives: Empowering Organizations to Manage Risks, Enhance Returns and Optimize Liquidity, ISDA and Boston Consulting Group, March 2025).
Using derivatives, the scheme can, in many cases, align asset durations with liabilities at a lower capital overhead than buying large quantities of long-term bonds (p 59). Using interest rate swaps, for example, occupational pension funds typically pay a floating rate and receive a fixed rate, helping them to manage interest rates movements.
Similarly, schemes may apply hedges to immunise against foreign exchange, equity and commodity price fluctuations and other market risk. More generally, derivatives may be used to capture exposure to market movements that may otherwise be hard to exploit owing to liquidity, transaction cost or other considerations.
Notwithstanding, some corners of the defined benefit (DB) pension plan sector have been subject to criticism in recent times for how they have managed liability hedges and associated margin requirements. The September 2022 UK gilts crisis triggered calls for an extensive review of how defined benefit pension funds utilise liability-driven investment (LDI), particularly leveraged LDI, and how they safeguard access to eligible collateral.
Impact of the gilts crisis
In the UK gilts crisis in September-October 2022, some LDI funds expressed significant difficulty in meeting margin calls on their derivatives and gilts repo positions, pushing them to sell down gilts in a falling market to generate liquidity to meet their margin requirements.
While some LDI-PI schemes did experience problems as gilt prices spiralled downwards, others were better prepared to withstand this price movement. The market has since focused on bolstering defenses, particularly around managing market stress and collateral management.
For Danielle Markham, Principal and Head of LDI Research at Barnett Waddingham, the fundamental principle – for a pension fund to structure its assets to align, as closely as possible, with future cash flow requirements – is still highly valid. The primary objective of a pension scheme is to pay benefits to scheme members as they fall due.
Since the gilts crisis, many DB schemes have continued to apply asset-liability matching strategies according to this principle. Larger pension schemes may operate segregated portfolios that are managed in house or through a specialist LDI manager. Smaller schemes may typically gain access via pooled LDI funds.
However, the industry has taken time to re-evaluate the ability of LDI schemes to meet their collateral and liquidity management requirements under different market conditions – and this has been a valuable exercise in improving levels of resilience across the sector.
Boosting resiliency post UK gilt crisis
Following this gilts shock, the Bank of England Financial Policy Committee issued recommendations on 29 March 2023 that the Pensions Regulator, in coordination with the Financial Conduct Authority and financial supervisors in other jurisdictions, should ensure that arrangements are in place to protect the resilience of LDI funds. These recommendations specified that LDI funds should be able to withstand “severe but plausible stresses” in the gilts market and they should be able to meet margin calls without asset sales that could result in negative feedback loops – implying that it is able to withstand a yield shock of at least 250bps.
Reflecting on the crisis, JP Morgan recounts that 30-year UK gilt yields rose more than 1.60% in a period of less than three days in September 2022. “For UK DB pension schemes that typically manage their liquidity based on a scenario of bond yields rising by 1% over a period of a week or more, the size and unprecedented speed of this increase created a perfect storm,” it says. These schemes quickly had to access collateral to meet sizable margin calls on interest rate swap and FX forward positions. The intraday range of 127 bps on the 30-year gilt in just one day exceeded the annual range for 30-year gilts in all but four of the past 27 years.
The Bank of England’s Gabor Pinter notes in a staff working paper that transaction costs, an indicator of market liquidity, rose sharply from 23 September, impacting nominal gilt trades in the days that followed and extending to index-linked bonds. While the outbreak coincided with selling pressures in long-dated ‘linkers’ by the LDI-PI sector, transaction costs climbed quickly among other non-LDI-PI clients. This also carried over into short-dated nominal bond trades, indicating that illiquidity was spilling over across clients and assets.
With these developments, the 2022 gilts crisis shone a spotlight on ‘collateral resilience’ and the need for pension funds to ensure access to cash or cash-like liquid instruments to meet margin calls.
But the Pensions Regulator has recommendations in place, advising that pension funds should maintain effective operational and market stress buffers. In holding an operational buffer, schemes are required to maintain sufficient liquidity, through cash, cash-equivalents and other eligible assets, to manage day-to-day volatility and resultant margin calls. The market stress buffer represents an additional liquidity buffer to provide resilience during periods of severe market stress. These elements are cumulative. If a scheme’s operational buffer is set at 100 bps, and the market stress buffer at 250 bps, the total buffer will be 350 bps.
Given that the Pensions Regulator has long required LDI-PI funds to maintain effective operational and market stress buffers, why did some get caught out during the gilts crisis?
In truth, pension schemes that were well advised and well prepared largely did not get caught out and were able to negotiate their margin requirements during the period of market stress, albeit with some discomfort. The Bank of England’s Pintor observes that the distress was concentrated among a small number of firms. He finds that three firms accounted for over 70% of total gilt sales of the LDI-PI sector to primary dealers during the crisis (p 1). “This is consistent with the LDI-PI sector being highly concentrated, with a few firms generating most of the LDI-PI activity in the UK market,” he says.
The distress must also be understood in terms of the specific market conditions that developed in Q3 2022 and the period leading up to the gilts crisis. “In the first half of 2022, many DB schemes were meeting the operational buffer requirement,” reflects Barnett Waddingham’s Markham. “We worked closely with clients to ensure that as yields rose during Q1 and Q2, these buffers were replenished. Consequently, when the gilts crisis took a hold during Q3, these schemes were holding healthy buffers such that they were able to manage collateral calls as gilt yields spiked.”
In contrast, for other schemes that had not managed their collateral buffers effectively [none of which, Markham emphasises, were advised by Barnett Waddingham] in months leading up to the gilts crisis – and for funds that had a sizeable part of their asset allocation held in illiquid assets – this presented problems when, in conditions of high price volatility, these schemes were required to post additional collateral against their derivatives exposures.
“For Barnett Waddingham clients, the message has always been that sound collateral management is key for clients that have a leveraged portfolio,” explains Markham, “requiring access to collateral that is liquid, relatively low volatility, that can be accessed in a wide range of market conditions and has low associated transaction costs.”
Winding forward to the present, Joe Dabrowski, Deputy Director of Policy at the Pensions and Lifetime Savings Association (PLSA), believes that stronger current funding positions at many pension funds, alongside the steps taken since the gilts crisis to strengthen collateral buffers, has substantially improved levels of resilience.
“As gilt yields rise or fall, pension funds will typically adjust their collateral holdings,” says Dabrowski. “In keeping with guidance from regulators following the mini-budget crisis, schemes are required to hold increased buffers to withstand market volatility – taking these steps is the prudent thing to do. Overall, DB pension schemes are currently in significant funding surplus and in a robust position to deal with market fluctuations.”
Since the UK gilts crisis, many LDI managers have taken steps to increase the resilience of their mandates, comments Markham, in many cases adopting target levels that are higher than those required by financial supervisors – which typically requires a scheme to maintain resilience to a 300bps increase in yields. From a collateral eligibility perspective, this has been accompanied by a widening of eligibility criteria to include a broader range of high quality, liquid non-cash collateral. Beyond cash, this offers additional flexibility for pension schemes to post government bonds as collateral, along with investment grade credit and some other securities-based collateral that may be accepted by the specific counterparty.
In parallel, we are now at a point where many DB schemes are well funded and they are well hedged in terms of interest rate and inflation risk. The macroeconomic environment has evolved since August 2022, central bank tightening has contributed to higher gilts yields and this has resulted in stronger funding ratios for many DB schemes.
With this development, DB schemes are needing to employ lower levels of leverage to move themselves to a position where they can potentially consider a buy-out – whereby the scheme’s assets and liabilities are sold to an insurer.
Given the specific conditions experienced during the gilts crisis of August 2022, a 1-2% movement in gilts yields was sufficient to push some DB schemes – notably those that had not retained adequate collateral buffers – into difficulties in meeting associated margin calls.
In contrast, under current market conditions [at the time of writing in early April 2025], with gilts yields at close to 4.75%, Barnett Waddingham estimates that yields would need to move 3-4%, within a period of 1 or 2 days, to have a comparable impact.
Reinforcing the toolbox
In negotiating this journey, pension consultants are working closely with DB schemes to ensure they are making best use of the toolset available. Many of these tools have been available for some years, but they are now being applied more widely and new tools are constantly being added.
For example, a DB scheme may employ gilt repo alongside interest rate swaps to manage interest rate risk and maturity mismatches – utilising repo on its inventory to generate liquidity to buy gilts of appropriate maturity to match its expected cash flows, In parallel, it may also apply IRS contracts – when appropriate to the market conditions and scheme requirements – to hedge, or to generate return, from potential interest rate movements.
In applying this toolset, Barnett Waddingham’s Markham indicates that it is important to apply an integrated approach to risk hedging across the scheme as a whole – rather than through a methodology that is siloed by asset class or instrument type.
By holding investment grade credit, for example, a scheme will generate cash flows to pay benefits, while at the same time providing a hedge for interest rate risk. However, this will not provide inflation protection – so a corporate bond mandate may need to be accompanied by an interest rate swap overlay to manage this associated inflation risk.
Some pension schemes are utilising derivatives to hedge longevity risk – aligning scheme assets to the life expectancy of scheme members. Ultimately, many schemes are seeking to undertake a buy in with an insurer such that everything is locked down.
Research is ongoing in the pensions industry to evaluate in which conditions a buy-in is the best decision. If the price of the buy-in contract is particularly expensive, for example – requiring a large pay-in from the plan sponsor to lock down the fund – it may be prudent to continue to operate the scheme, generating return from scheme assets prior to locking down through a more favourable contract at a later time.
Commenting on strong ongoing levels of risk-transfer activity from UK pension funds, Lara Desay, Head of Risk Transfer at Hymans Robertson, observes that bulk annuity transactions of £47.8bn, and a record breaking 299 transactions, reflects the continued buoyancy in the risk transfer market. “With many providers hitting record annual volumes and with the recent entrance of new providers Utmost and Blumont, capacity continues to increase, and competition is at an all time high. We expect demand from pension schemes across all sizes to remain high in 2025.”
