Without the Bank’s decisive action, it is no exaggeration to say that the UK faced a pensions meltdown in which as many as ten million people with gold-plated ‘final salary’ schemes would have been affected. One investor told the Financial Times that 90pc of UK pension funds would have been “wiped out”. The problem stems from a massive new bubble that has been allowed to develop in something called Liability Driven Investments.
An estimated £2.5 trillion sits in UK private-sector pension funds and the assumption is that most of that money is safely tucked away in assets such as government bonds and shares. That is true, but only up to a point.
Pension schemes typically invest more than half of their assets in gilts, in order to meet future long-term liabilities. But ultra-low interest rates have left yields on a steady downward trajectory for the last 25 years. This pushes up the accounting value of pension fund liabilities, so increasingly fund managers have sought to hedge their UK government bond positions through LDI trades.
Pension schemes use LDIs to offset the swings in their liabilities stemming from bond market volatility by investing in other more high-growth assets such as corporate debt and mortgages. But there’s a further layer of complexity because investment managers then hedge the risks further through derivatives, often using existing bond assets as collateral against the contracts.
Anyone with a private pension may be shocked to learn that the amount of liabilities held by UK pension funds hedged using LDI strategies has roughly tripled in size to £1.5 trillion between 2010 and 2020, the equivalent of roughly 40pc of the UK institutional asset management industry.
What is more surprising is that the £1 trillion tied up in Government bonds proved to be the weak link in the chain. As gilt yields rose sharply on the back of an almighty sell-off, bonds were suddenly worth less than the loans made against them. Spooked creditors demanded extra collateral to cover their positions.
The Bank of England’s emergency £65bn bond-buying programme saved the day. It quickly brought yields back down, helping to calm the market. Without it, there would have been fire sale of assets, including perversely more of the same bonds, as pension funds scrambled to raise cash to meet margin calls. Former Governor Sir Mark Carney said that if the Bank had failed to act, the knock-on effects “would more than ripple” they “would cascade through financial markets.”
Still, it is patently absurd that all it took was little more than a 1 percentage point spike in bond yields to threaten to bring the entire house tumbling down.
There should now be an immediate and full-scale investigation into the extent to which this opaque and little-known corner of the financial world represents a genuine risk to UK financial stability.
Any enquiry must look at how this market was able to balloon to such a jaw-dropping size seemingly without any meaningful intervention from the regulators. It’s not that the explosion in LDIs went unnoticed. One of the first whistleblowers was Next boss Simon Wolfson, who was so alarmed by the potential risks that he instructed the company’s treasurer to alert the Bank of England.
The Bank’s Financial Stability Report raised its own concerns in 2018. Then in 2019, the Pensions Regulator highlighted that nearly two thirds of the biggest UK pensions had at least some exposure to interest-rate swap derivatives. In 2021 senior risk managers at the Bank of England expressed further fears, and in July this year, analysts at insurance giant Aon urged pension schemes “to be ready to manage bond market volatility”.
The responsibility for the mayhem in markets ultimately lies with the Government and its disastrous mini-Budget but the Bank of England cannot expect to escape scrutiny. Yes, it acted decisively to prevent a full-blown financial crisis but it allowed the problem in the pensions market to fester in the first place. Not for the first time, Threadneedle Street looks to have been caught napping as a major scandal erupts under its nose.
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