Explained: UK's Pension Fund Crisis

Pension funds are supposed to be low risk, that's their entire purpose. Their primary goal is earning enough money to make payouts to those who have retired.

Pension fund managers don't really expect themselves to be at the centre of financial volatility, as pension fund managers aren't over optimistic risk takers. Their expectation seems natural.

However, this expectation of their was shattered when Liz Truss' government announced its mini-budget on the 23rd of September.

Markets went haywire after the mini-budget proposed unfunded tax cuts.

Investors started dumping the pound and UK government bonds. This led to yields on some of that debt rising steeply.

Eventually, the Bank of England was forced to step in with emergency bond buyback measures.

How does this relate to the pension funds? Well, pension fund managers noticed trouble in LDIs. LDI refers to liability driven investment.

The main goal of LDIs is to ensure pension funds have enough money to pay what they owe to the retirees. As people retire only after a certain age, the payouts are expected to be 30-40 years in the future.

To plan for these payouts, fund managers buy long-dated bonds. Derivates are purchased along with the long-dated bonds to hedge the bets.

This process entails offering a collateral. If bond yields rise rapidly, even more collateral has to be offered in what is usually known as a 'margin call'.

If bond yields rise slowly, it doesn't hurt pension funds relying on LDIs as a strategy. It actually helps the finances of the funds. However, if bond yields rise sharply, it is problematic.

Since the mini-budget's announcement, margin calls kept coming in. The pension protection fund faced a £1.6 billion call for cash. The pension protection fund was unable to pay this without dumping assets.

Ben Gold, head of investment at XPS Pensions Group, a UK pensions consultancy, said that, "it started to feed itself. Everyone was looking to sell and there was no buyer."

As the meltdown became evident, the Bank of England decided to buy upto £65 billion in bonds, in an effort to stop a “self-reinforcing spiral” and “widespread financial instability.”

According to a letter written by the Bank of England to the head of the UK Parliament’s Treasury Committee, the central bank believes that if it hadn't intervened, several funds would have defaulted.

It is being estimated that around half of the "400 pension programs that XPS advises faced collateral calls." Funds are now racing to fill a hole of around £150 billion. It isn't clear if funds will be able to do it before Bank of England's scheduled end date for the emergency measures.

Central bank's purchase of bonds has ensured that the yields on longer-term bonds decline. This has provided pension funds with the time they desperately needed.

Bank of England's previous plans of selling bonds at the end of this month, bonds it bought during the pandemic, might complicate the situation.

The fact that central banks around the world are hiking their interest rates sharply means investors are jittery about the impact of high interest rates on their portfolios and on the economy in general. As a result, investors are holding more cash, which leads to more friction in the execution of trades. Jarring price moves are sharpened in such a scenario.

For now, the Bank of England has stated that it will continue with its emergency measures beyond their scheduled end date. The announcement was made by the central bank yesterday.

In recent years, the quiet corner of pension funds has grown rapidly. According to the Bank of England, it has attained a valuation of more than £1 trillion. This near call will be a learning moment for many.