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Accident waiting to happen: £1.5 trillion time bomb ticks away
Pensions are believed to be one of the safest and calmest backwaters in the turbulent world of high finance. But to the horror of savers who rely on supposedly gold-plated final pay schemes for retirement, a £1.5 trillion time bomb is ticking under their money.
And the Bank of England and the pension regulator, who should have been protecting their nest eggs, have watched as the risks of an explosion mounted. They allowed some of the UK’s largest occupational pension schemes to take on dangerous investment strategies that blew up the entire system in no time last week.
The government bears the brunt of the near-disaster. But the finger also points straight at the Bank of England, which has been aware of the lurking dangers for years. Workplace Retirement Watchdog The pension regulator has also been accused of tardiness in the face of increasing risks.
The terrifying near miss is another blow to the credibility of Bank of England governor Andrew Bailey, who is already under fire for not acting fast enough to curb inflation.
The mini-budget was the immediate cause of the impending collapse of final salary pensions. Shocked by the surge in loans, investors demanded higher interest rates on UK sovereign debt, which they said had become significantly riskier.
The deeper question is why regulators have allowed pension funds to end up in such a precarious position in the first place. In particular, why did the Bank of England stand idly by while funds pursued risky investment strategies on such an epic scale? And why did the Pensions Supervisor – whose chair in one of its previous jobs was a major player in the investments involved – sit on his hands?
Using leveraged Liability Driven Investments (LDIs) was a very obscure practice until a few days ago.
Even many seasoned City professionals had never heard of it. They are built on debt that, as we saw last week, can be toppled as easily as a house of cards.
Here’s what would have happened if the Bank of England hadn’t stepped in to avert a ‘doom loop’ – even though it should never have built it in the first place.
This scenario did not come out of the blue: the risks of LDIs have been known for years. A Dutch fund manager warned in 2019 that they pose a ‘terrible’ threat to the global economy.
Lord Wolfson, director of fashion chain Next, warned the Bank of England about the dangers of LDIs five years ago. He said he was bombarded with sales pitches by investment banks seeking to make lucrative fees. Due to the Bank of England’s inaction at an earlier stage, it was forced last week to launch a bailout for a potential £65bn, with taxpayers footing the bill.
“People have warned about the risk,” said former pensions minister Sir Steve Webb. He said the Bank of England should have been aware of the matter.” Webb added: “It put out the fire, but it didn’t prevent the fire.” The Bank tried to evade responsibility this weekend by saying it is not the regulator of pension funds or LDIs. However, it is tasked with the stability of the financial system as a whole.
Pension fund directors also have to deal with settlement. They are responsible for securing members’ benefits, but have allowed LDIs and other derivatives to introduce more risk into their portfolios.
“I can count on the fingers of one hand how many trustees understood the enormous risks they were taking,” says pension expert John Ralfe. “They were urged on by investment advisers, who have made a fortune in recent years.”
The catastrophe brush brings back uneasy memories: of the 2008 financial crisis, which exposed the use of dodgy derivatives, and of past pension scandals, including Robert Maxwell.
The LDI debacle is dramatically bigger than the Maxwell affair, when the late tycoon robbed Mirror Group Newspapers’ pension fund more than 30 years ago. The irony is that huge efforts have been made to make pensions safer since Maxwell, but the risks are greater than ever before.
Relief! Why your retirement income is still safe
The dramatic £65bn Bank of England intervention has removed the immediate threat to pensions. If the arrangements in place run into problems, the employer is still responsible for the payment of the pensions and if the company becomes insolvent, there is a Pension Protection Fund that intervenes.
How many were at risk?
About ten million participants in defined benefit plans, also known as ‘final pay plans’, were affected. So-called defined contribution plans, in which payouts are linked to stock market performance, were out of the question.
Shouldn’t they be ultra-secure?
Indeed. That’s why the risks revealed are so shocking. As the name suggests, final pay plans offer a lifelong guaranteed retirement income that is tied to your pay when you leave work.
What went wrong?
Pension fund managers must ensure that they have enough in the pot to pay retired employees in the future. Their assets include notes of debt issued by the UK government, known as gilts. These offer a fixed return and can be bought and sold by investors. If the price of the gilts falls, the yield rises. Their value is influenced by the confidence that investors have in the creditworthiness of the UK government. The riskier they think the debt is, the higher the returns investors will demand.
What happened last week?
As investor concerns about the mini-budget mounted, they sold gilts. As a result, yields rose at an unprecedented pace in a normally quiet market.
I’m with you so far…
Good, because there is more. Many pension funds use leveraged Liability Driven Investment (LDI) strategies. Simply put, the funds put the gilts they own as collateral to borrow money, which they use to buy another investment.
They can repeat that process and re-borrow against the new assets, repeating it several times.
But if, as happened last week, the price of gilts falls, the collateral becomes worth less. So lenders asked pension funds to pump up huge sums as extra security.
The speed and magnitude of the moves in gold prices threatened to trigger a liquidity crisis, as the funds didn’t have the cash to hand, and were thus forced to sell assets. Without intervention, it would have pushed gold prices down further and created a ‘doom run’.
By intervening and promising to buy up the gilts, the Bank defused the ticking bomb.
How much of this has gone through?
LDIs have exploded in popularity in recent years and now account for around £1.5 trillion in assets in people’s pension funds.
Has anyone seen the iceberg?
Regulators responsible for financial stability were repeatedly warned about the risks of leveraged LDIs, but did nothing.
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