Employers pay a great deal into pensions, whether to fund defined benefits or to help staff build a pension pot. They pay a relatively small amount to explain how pensions work and most of the awkward questions people have can go unanswered because the people staff talk to about financial matters – talk among themselves!
So I’m using this blog to deal with some of the questions I get asked. I get asked them by my friends (on my boat mainly) about what really happened in September following the mini-budget, which made pensions – for a few days – front page news.
If you happen to be being asked these questions or asking these questions yourself, I hope you find this useful
So why did pensions find themselves at the heart of the crisis?
It’s important to start out by saying that pension schemes are not and were not in danger of going bust! The problems they had, which created great instability in the financial system and required the Bank of England to promise they’d buy up to £65bn of their debt back, was to do with liquidity not solvency. Of course, you can become insolvent if you haven’t got ready cash to pay your bills but there was never any question that pensions weren’t going to get paid. The bills that pension schemes needed to pay in a hurry were demands originating from investment banks to post collateral so that the complicated financial plumbing known as LDI could be kept in place.
If the collateral had not been out in place, then the complex apparatus that supported pension scheme funding would have disappeared. This is the immediate cause of the crisis, but people should be asking why LDI was a part of their pension scheme in the first place.
LDI (liability driven investment) is a very sound concept, it means you invest money to make sure that when pensions come due (liabilities), there is money to pay them. Put simply – that’s what pension schemes should do.
The problem that sparked this very artificial crisis stems from an obscure accounting standard introduced into pensions in 2004 which required schemes to value themselves using a very strict measure based on the present (not the future) value of assets. This caused employers headaches and the banks found they could help out by offering financial engineering which involved stabilising the pension scheme’s liabilities on the balance sheet without ruining the employer’s cashflow.
This financial engineering (LDI) worked very well so long as the cost of Government borrowing remained low. But because the mark to market system value everything with reference to the long term cost of borrowing, when that started going up the financial engineering started to unwind.
There had been stress testing of this happening, but apparently this hadn’t included the huge increases in the cost of borrowing imposed on the Government because of the market’s view of the now infamous mini-budget.
For a few weeks in late September and early October, our pension schemes were forced to sell anything they could get a reasonable price for, to meet the bills from the bankers. This included selling some of the Government debt they’d been buying with the very money they’d raised through the financial engineering. If there hadn’t been a market for this debt, it could have become valueless which could have led to a financial crisis. That’s why the Bank of England stepped in.
So pension schemes are right to say that this was an artificial crisis, caused by accounting standards which drove them towards LDI. They are also right to say that because of the rise in the cost of borrowing, pension schemes are now technically much more solvent. But they know that they had to be saved from a liquidity crisis by the Bank of England and it’s now unlikely that they will employ LDI in quite the same way.
This begs a lot of questions which I can’ answer in this article but it does allow you to make some very simple statements about what has happened
- The “LDI crisis” was very real and very dangerous and shows the value of having a strong central bank
- Pension schemes are not insolvent – in fact they are now much more solvent because of interest rates going up.
- Some pension schemes invested in a way that they did not properly understand and got caught short after the mini budget. Those schemes are going to have to reorganise how they manage their assets and liabilities.
You say “LDI (liability driven investment) is a very sound concept, it means you invest money to make sure that when pensions come due (liabilities), there is money to pay them. Put simply – that’s what pension schemes should do.”
This is mistaken at two levels – First LDI has never been a sound concept, let alone a very sound concept. It is a strategy which is concerned with the variability of valuations and has nothing to do with paying the ultimate benefits promised to members. In fact, it destroys one of the prime advantages of long-term savings and reduces their concerns to the day to day of markets – in other words it introduces all of the problems of maturity mismatch well known in banking into what were before our principal long-term savings institutions.