One of the more alarming aspects of last week’s near-financial meltdown in the United Kingdom — apart from the sheer stupidity of Liz Truss and Kwasi Kwarteng’s massive, unfunded tax cuts for the rich — was the apparent lack of understanding of what might happen to the UK’s £1.3 trillion defined benefit pensions sector if markets decided its fiscal policy was out of control and the cost of government borrowing — via bonds — needed to rise to cover the risk.
Over the past two decades, UK pension funds have been encouraged by financial regulators to adopt liability-driven investment (LDI) strategies — often using derivatives — aimed at ensuring current and future liabilities of the pension plans offered by funds are covered. Many of these funds — about 5200 serving 10 million members — offered defined benefit products, as opposed to defined contribution schemes, which are typical in Australia — think ordinary super funds, where the benefits reflect investment returns. Defined benefit products require quite different investment strategies to provide the benefits guaranteed to members.
These strategies require cash collateral to be held with an LDI manager; more cash may need to be added in response to market moves. Last week’s sharp spike in long-term bond yields (which mean a fall in bond prices) saw pension funds using LDI strategies face unprecedented demands for more cash. Schemes that could not meet these calls risked defaulting or having their hedging positions closed.
These funds dumped bonds as they sought emergency collateral to remain invested in derivatives — and did so into a bond market where the Bank of England was also selling bonds, as part of its quantitative tightening program. That’s why the BoE reversed course and began a temporary program of buying bonds once again — as it did during the pandemic — to keep bond prices from collapsing further.
It is clear from the reaction that not many people outside the UK pension industry — not the media media, politicians, other regulators or even UK Treasury — had an understanding of the damage a surge in bond yields (and slump in prices) could do to the defined benefits sector and thus the financial system.
Worse, the surge in bond yields also drove up borrowing costs for UK banks — bringing UK home lending to a shuddering halt.
At the weekend it became clear that defined-benefit pension sector was still having to sell other assets to raise cash to meet margin calls, despite the BoE intervention: shares, bonds, any liquid investment. Some are reported to have sought bailouts from their corporate backers.
The problem is, the BoE has committed to its bond buyback program only until October 14 — it’s just buying time for the pension funds. Daniela Russell, head of UK rates strategy at HSBC, told the Financial Times “with a possible cliff edge when this is due to end … the bank may consider offering more support“.
That sentiment is being echoed around global financial markets.
Come October 14, if Truss and Kwarteng still have their £45 billion tax cut package and it’s still unfunded, markets will resume as they did last week — requiring the BoE to keep buying bonds. Remember the BoE, as part of its anti-inflationary tightening of monetary policy, and to wind back pandemic-era stimulus no longer needed, had only recently embarked on selling bonds. It’s anxious to resume that.
(Truss has now suggested that public services would be cut to pay for the tax cuts. The idea of a Tory government slashing public services to pay for tax cuts for the rich will cause riots in the streets — even Tory MPs are issuing pre-emptive warnings against it.)
One option being suggested is to formalise the BoE’s bond-buying operation into a permanent facility that could be triggered if there were repeats in the circumstances we saw last week. That would be similar to the facility the Reserve Bank here has had in place since the financial crisis, when there were not enough Commonwealth government bonds on issue to provide necessary liquidity for the financial sector. Following the surge in Commonwealth debt in the pandemic, that facility ends this year.
At the weekend the House of Commons work and pensions committee announced it intended to write to the pensions regulator for an explanation of what happened last week. That tells us a lot about the high level of ignorance in the UK Parliament about how the country’s retirement and investment sectors mesh. The scarier story is the prime minister and chancellor of the exchequer don’t understand either.
