It would be fair to say that the fallout from the government’s 23 September “mini-Budget” was more far-reaching than anyone could have predicted.
The immediate market reaction to the statement – and former chancellor Kwasi Kwarteng’s subsequent comments about further tax cuts – sent markets into meltdown. The pound fell to an all-time low against the US dollar, while the cost of government borrowing immediately spiked.
Of course, the Growth Plan led to the premature demise of both the chancellor and prime minister, with new chancellor Jeremy Hunt having already reversed most of the measures announced in the September statement.
You may have seen the headlines immediately after the mini-Budget claiming that many pension funds were at risk of collapse. Read on to find out why pensions were affected, and whether it is true that pension funds nearly did go bankrupt.
Pension funds struggled to meet their collateral requirements
In the aftermath of the mini-Budget, there was a huge sell-off of British government bonds (“gilts”) as investors began to lose faith in the credibility of the Truss administration to run a sustainable tax and spending policy. This caused the rate of return the bonds generate (the “yield”) to dramatically increase.
This affected defined benefit (DB) or “final salary” pension funds because the pension schemes typically invest more than half of their assets in bonds, in order to pay pension liabilities decades into the future.
To avoid exposure to market volatility, these pension schemes typically hedge their positions through gilt derivatives managed by so-called “liability-driven investment” (LDI) funds overseen by major fund managers such as BlackRock, Legal & General, and Schroders.
These are largely leveraged funds. So, when they buy gilts, they frequently use them as collateral to raise cash and then use this cash to buy more gilts, then pledge the gilts again and buy more gilts, and so on.
If yields rise too far and too fast – as they did after the mini-Budget – these pension schemes need to provide more cash to the LDI funds because they end up paying out more money in the transaction than they are receiving.
The funds invested in LDI schemes faced rolling “margin calls” as the value of the bonds they had pledged as collateral collapsed.
When the value of gilts fell after the mini-Budget, pension funds had to sell more to raise the same amount of money to repay their loans. As more gilts were sold, their value fell further, and this risked creating a “doom loop” that could have left some pension funds unable to pay their debts.
These margin calls required the pension funds to provide collateral immediately, and the schemes may only have had a day or two to find this cash.
Cardano UK CEO Kerrin Rosenberg told Investment Week: “When you get these cash calls from your managers, you normally you have three or four days to respond.
“But we saw a 200-basis point rise in three days, and when managers asked for cash, instead of giving you four days, they gave you just one day to provide the cash”.
The Bank of England stepped in to calm the market
The Bank of England (BoE)’s intervention – they stepped in to buy billions of pounds of British government bonds – calmed the market, as it gave pension schemes time to process transactions in an orderly manner to secure their positions.
Essentially, the BoE intervened on 28 September and promised to buy gilts to stop their price dropping any further. This effectively acted as a backstop and put a floor on the price of a gilt and a ceiling on the yield.
This gave schemes time to sell assets in a more orderly way, such that the repricing of the gilts didn’t lead to a market bloodbath.
Did pension funds nearly go bust?
According to the BoE, many pension funds did come close to collapse.
The Guardian reports that the central bank said pension funds with more than £1 trillion invested in them came under severe strain with a “large number” in danger of going bust.
Had the BoE not intervened with a promise to buy up to £65 billion of government debt, these funds “would have been left with negative net asset value” and cash demands they could not have met.
“As a result, it was likely that these funds would have to begin the process of winding up the following morning,” the Bank said.
What this means for your pension
It’s important to note that these issues apply only to DB (or “final salary”) pensions. It doesn’t affect the State Pension or “defined contribution” (DC) – or money purchase – pension schemes. Most workplace pension schemes, and all personal pension plans are DC schemes.
As long as the employer sponsoring your pension scheme remains solvent, there is little risk of your pension not being paid in full.
One of the reasons is that that the pension regulator calculates the value of a pension scheme’s liabilities by using a discount rate on the future cash value of pensioner payments that is linked to the gilt yield. When that yield rises, the present value of those liabilities actually falls.
So, paradoxically, even though pension funds could have collapsed without BoE intervention, pension funds should emerge stronger from recent events.