Out from the eye of the storm

Predictably, the PLSA called upon the Bank of England to provide ongoing support for the pension funds which had either directly or through pooled funds, geared up their bond exposure through “borrowing”.

“Borrowing” is what the Bank of England thinks schemes have been doing and there appears to be zero sympathy for schemes that continue to be exposed to collateral calls after the end of this week.

I am at the Pension and Lifetime Savings Conference in Liverpool and I was asked last night what I thought the worst case scenario for a pension scheme is after this week. My answer was blunt, in the worst case the call from the bank on the other side of the derivatives contract is so big that it bankrupts not just the pension scheme but its sponsor causing the scheme to go into the PPF and the sponsor to go out of business. That is unlikely but it is possible because there is unlimited liability to collateral calls, they are created by what happens to the gilt yield which could go up exponentially.

This is the worst case scenario , which is why the process of down-selling the leverage of pension schemes on their LDI portfolios will have to happen pretty damn quick. Andrew Bailey told the pension schemes to be prepared for what happens when the Bank’s support stops and refused to countenance supporting pension schemes after this Friday (14th October).

This is likely to come as a shock to the pension schemes and as one of two people charged with leading the debate on “the current economic situation” at 9.30 this morning, I am not going to be pulling my punches. Anyone who was at the Pension PlayPen coffee morning with Con Keating yesterday (or at the TUC call in the afternoon) will know what I will be saying

It is argued that LDI has served pension schemes well for the past 20 years, that argument is made by those who advised on and set up LDI portfolios and funds. The demand for LDI was created by the Pension Act 2004 and the accounting standard that required schemes to value assets on a mark to market basis. It was successful because of quantitative easing which kept interest rates and bond yields artificially low since the financial crisis and pension schemes have moved from adopting LDI as a tactic to counter low yields (and high bond prices) to a strategy to exploit the ongoing luxury that QE created.

LDI should have remained a short term tactic but it didn’t and sooner or later the strategy was going to go wrong, this happened in 2022 and in particular the last few months which have seen interest rate rises and the prospect of more rises. Sensible funds like the PPF have seen the writing on the wall and have been reducing their borrowing but even it reports a billion pound exposure to cash calls from its bankers.

The estimate is that over £200bn has already been posted by pension schemes as cash which gets paid to investment banks if gilt yields hit certain levels. There is a potential £250bn left to find and that is either being found to keep “hedges” in place or hedges are being abandoned, meaning that the loss of the “synthetic gilts” purchased though derivatives which are being abandoned.

So up to half a trillion pounds could possibly be paid by pension schemes to banks to meet obligations and that means a firesale of the assets that pension schemes purchased to meet obligations. These are the growth assets which the Government is relying on to increase Britain’s productivity.

So the situation is bad for pension schemes and for the new Pensions Minister who I understand is going to be called the Minister for Pensions and Growth.

Pension schemes are unlikely to have weaker balance sheets in the short term. That’s because of the bizarre mark to market accounting standards that allow them to use the very instrument that threatens them – high gilt yields, to mark down their liabilities and make them technically much more solvent. But everybody knows that schemes cannot hide behind that accounting convention for ever. When the tide comes in and gilt yields revert to lower levels, the damage to the funds asset base will become clear. Some schemes will find it much harder to float, some will not be able to afford the repairs needed because they will not have recourse to sponsors deficit contributions.

If you don’t take my word for it, this is how Edward Al-Hussainy of Columbia Threadneedle summarises the worst-case scenario:

The Bank of England entered the market, which is dislocated because of the pension funds’ need for liquidity. It says, you guys are desperate, sell at today’s low prices; we’re not paying you what the bonds were worth two weeks ago. But the pension funds really don’t want to be forced sellers and crystallise losses on their bonds. They say, this market is going to be better next week, we’re not selling here.

So, hypothetically, the pension funds might not sell and the Bank might not buy. And next week, the BoE is out of the market. Let’s say yields go up again. The pension funds face another margin call. But there is no BoE this time, and the funds have to liquidate at even lower prices . . . this is how a liquidity problem can turn into a solvency problem.

That is the worst case scenario, better talk of it. That’s what I hope we do these next two days. I hear that there are some members of the BoE Fiscal Policy committee which meets today who want to take Andrew Bailey to task and are going to press for extension of some of the interventions. There may be hope for pension schemes but it’s a high risk game of brinkmanship that’s going on.

Anyone who is not involved in LDI will (or should) be asking the same question. “why didn’t pension schemes see this coming?”. This blog hasn’t been the only place where warnings have been posted but there haven’t been many others. I suspect that most people in pensions think that pensions are too big to fail which is what banks felt in 2007.

The PLSA has been issuing soothing notices to the market , most notably an email to members from CEO Julian Mund. But if the Bank of England cannot calm the sea , then how can the pension funds and their representatives?

The reality is that schemes are going to have to stress test for potential levels of gilt yields in excess of 7% and be prepared to lose their hedges if they cannot post collateral to meet calls if yields go that high. They may not bother and just hand over the keys to the car/house/hedge (choose your analogy). Repo Man is coming and if you don’t have the cash, you lost the car/house/hedge.

Of course everything could be alright and the markets may feel that there is sufficient confidence in a contrite Chancellor and Prime Minister to wait and see till they publish this fiscal plan on 31st October. That plan may satisfy the OBR (and IFS) which may satisfy the markets. Who will pay for the plan? Why the same people who paid for the last one – the poor.

The general public will pay through cuts in public services and benefits which they rely on and the wealthy have no need of. That’s because Plan B , which used to be “raise taxes” is now to “punish the unproductive”. That’s how “growth” works.

And of course we will all be paying a lot more interest on our mortgages. But heh – that’s good for the banks.


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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7 Responses to Out from the eye of the storm

  1. John Mather says:

    Please don’t call DB schemes “Gold plated” ever again

  2. DaveC says:

    By your comment I assume DC pension recipients are going to take a hair cut?
    Or will the PPF and then government (young people in society) come to the rescue?

    I have this feeling they’ll remain gold plated.

    • John Mather says:

      I presume you mean DB
      I can see your point but only if they are guaranteed by the taxpayer This problem is big enough to bust the sponsoring company. Has the PPF exposure to this type of leverage?

  3. Tyler MCCLELLAN says:

    I agree entirely with the spirit of this post but some of the specifics don’t make a lot of sense or are flat out contradictory

    for example, and just to use (1),

    if in fact the pension schemes sell their “good” growth assets to meet margin calls, then their LDI portfolios will not in fact be unwound and if rates were to subsequently rally there would be no effect to the asset position (other than the chrystilization of the losses in the growth book)

    there are others but that is sufficient

  4. Gareth says:

    There is an old adage! KISS, the minute you go for fancy financial engineering you expose yourself to increased risk. Thank god only 1 of my pensions which are already in payment could be exposed to this, the others are government or DC

  5. Gareth says:

    From what I’ve read probably, as always when something looks so good people will buy it, there is no reason to suspect they weren’t in that group. Am I always clever enough not to fall something? I hope so, but I’m sure occasionally I can fall for it

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