UK defined benefit (DB) pension funds collectively manage over £1.5 trillion of assets and represent one of the most significant participant groups in the gilt and interest rate derivatives markets. Their investment behaviour is driven by a single overriding objective: matching assets to liabilities. Understanding how pension funds pursue this objective reveals a great deal about why long-dated gilt yields, inflation breakevens, and interest rate swap curves behave the way they do.
Defined Benefit versus Defined Contribution
A defined benefit (DB) pension scheme promises a specific retirement income to members, typically calculated as a proportion of final salary multiplied by years of service. The scheme sponsor — usually a corporation — is obligated to fund any shortfall between scheme assets and the present value of promised benefits. This creates the fundamental asset-liability matching problem: the liabilities are long-dated (payments to members stretch 30–50 years into the future), inflation-linked in many cases, and their present value changes with interest rates.
A defined contribution (DC) scheme, by contrast, pays into a fund on the employee's behalf; the employee bears all investment risk and the final benefit depends entirely on fund performance. DC schemes have no need for interest rate derivatives to hedge liabilities — they have no guaranteed benefit obligation. The shift from DB to DC across most large employers over the past two decades has reduced the pipeline of new demand for LDI strategies, but the stock of existing DB liabilities remains enormous.
Liability-Driven Investing (LDI)
Liability-driven investing is the approach whereby a pension fund constructs its investment portfolio specifically to offset movements in the value of its liabilities. The key insight is that pension fund liabilities behave like very long-dated bonds: when interest rates fall, the present value of the liabilities increases; when inflation rises, the real value of benefits (many of which are inflation-linked) increases. Without hedging, a falling interest rate environment would dramatically increase the measured deficit of the pension scheme.
Interest Rate Swaps in LDI
A DB scheme with significant duration mismatch between assets and liabilities will use receive-fixed interest rate swaps to add duration to the asset side of the balance sheet. By receiving the fixed rate on a 30-year swap, the scheme gains mark-to-market value when long-dated interest rates fall — exactly offsetting the increase in liability value. Because swaps require no upfront payment of notional, the scheme can achieve a large increase in duration without selling its equity and credit holdings. This leverage is central to LDI — a scheme can hold a growth asset portfolio (equities, property, credit) alongside a derivatives overlay that hedges the interest rate and inflation sensitivity of the liabilities.
Inflation Swaps
Many UK DB pension liabilities are linked to the Retail Price Index (RPI) or Consumer Price Index (CPI). Schemes use inflation swaps — where they receive RPI in exchange for paying a fixed rate — to hedge this exposure. The UK inflation swap market is dominated by pension fund demand, which makes it structurally different from most other swap markets: there is a clear and persistent directional bias in demand (pension funds are overwhelmingly receivers of inflation), which affects market pricing.
Gilt Repo in LDI
To fund the collateral requirements on their swap positions and to achieve additional duration without deploying physical cash, pension fund LDI managers routinely use gilt repo. A scheme's custodian pledges gilts to a bank under a repo agreement and receives cash, which can be used to meet variation margin calls on the swap portfolio or to purchase additional gilts. This creates a chain of leverage: gilts are used as collateral to borrow cash, which is used to buy more gilts or to meet margin calls on derivatives.
The 2022 LDI Crisis
In September 2022, the UK government announced a package of unfunded tax cuts in the "mini-budget" delivered by Chancellor Kwasi Kwarteng. The gilt market's reaction was swift and violent: 30-year gilt yields rose by more than 100 basis points in a matter of days, reaching levels not seen since 2008. This was, in isolation, a move that pension funds with LDI strategies should have been able to tolerate — they were holding receive-fixed swaps, which lose value when rates rise. The problem was not the market move per se, but the liquidity mechanics of how LDI strategies were structured.
As gilt yields rose, the swap positions of pension funds generated large variation margin calls — the funds owed cash to their swap counterparties (or to central clearing houses) to reflect the daily mark-to-market loss. To meet these calls, funds instructed their LDI managers to sell gilts. Gilt sales pushed yields higher still, generating further margin calls — a classic pro-cyclical feedback loop. The Bank of England intervened on 28 September, announcing a temporary programme of long-dated gilt purchases to restore order, explicitly noting that it had been informed of "a material risk to UK financial stability."
The episode revealed that many LDI strategies had been built with insufficient liquidity buffers — too little cash or near-cash held against the possibility of rapid interest rate moves. The Pensions Regulator (TPR) subsequently issued guidance requiring schemes to hold larger liquidity buffers and to stress-test their LDI portfolios against more severe rate moves.
Credit, Equity, and Regulatory Constraints
Beyond the rate and inflation hedge, pension funds invest in return-seeking assets: equities, corporate bonds, infrastructure, property, and hedge funds. The investment strategy must comply with the scheme's Statement of Investment Principles (SIP) and the requirements of The Pensions Regulator. TPR's guidance on integrated risk management emphasises the relationship between investment risk, funding level, and sponsor covenant strength — well-funded schemes with strong sponsors can take more investment risk; poorly funded schemes with weak sponsors face pressure to de-risk.
As schemes approach full funding — helped by rising interest rates in 2022–2023 — many have pursued "endgame" strategies: bulk annuity purchases (buy-ins and buyouts) with insurers, which transfer the liabilities off the corporate balance sheet entirely. This has created significant demand in the annuity market and has further effects on the gilt and credit markets as insurers invest the premium income.