Q&A
UK’s Bond Market Turmoil is a Wake-up Call for Pension Plans
The UK’s finances were plunged into chaos in late September, with the pound falling briefly to an all-time low against the U.S. dollar and a crash in the value of government bonds known as "gilts."
The uncertainty was sparked by announcements from the new UK government of plans for large unfunded tax cuts intended to spur the British economy and an unfunded cap on energy bills.
The market turmoil had a significant impact for UK defined benefit pension plans, many of which were hours from a potential liquidity crisis.
As government bonds rapidly lost value, pension funds that had invested in widely used leveraged liability driven investment funds (LDI) began facing margin calls from their investment managers, demanding additional collateral to back their leveraged LDI accounts. To meet this call, pension funds started selling off their gilts, thereby sending the price of gilts even lower. Pension funds found themselves caught in a doom loop of forced selling and falling liquidity.
To stem the selloff and prevent a liquidity crisis, the Bank of England intervened, indicating it would purchase government bonds over a two-week period to end the bond market turmoil. In effect, acting as a buyer of last resort.
The UK government has since rolled back the vast majority of its planned tax cuts and is planning to introduce other measures to reassure bond markets of its economic policy. There has also been a change at the UK Treasury with Jeremy Hunt replacing Kwasi Kwarteng as Chancellor of the Exchequer. The Bank of England’s measures, which ended on October 14, have returned some stability. Nonetheless the situation has provided a wake-up call for company pension funds.
Calum Mackenzie, investment partner at Aon, discussed the current situation in the UK, its implications for pension funds and what might be ahead.
The uncertainty was sparked by announcements from the new UK government of plans for large unfunded tax cuts intended to spur the British economy and an unfunded cap on energy bills.
The market turmoil had a significant impact for UK defined benefit pension plans, many of which were hours from a potential liquidity crisis.
As government bonds rapidly lost value, pension funds that had invested in widely used leveraged liability driven investment funds (LDI) began facing margin calls from their investment managers, demanding additional collateral to back their leveraged LDI accounts. To meet this call, pension funds started selling off their gilts, thereby sending the price of gilts even lower. Pension funds found themselves caught in a doom loop of forced selling and falling liquidity.
To stem the selloff and prevent a liquidity crisis, the Bank of England intervened, indicating it would purchase government bonds over a two-week period to end the bond market turmoil. In effect, acting as a buyer of last resort.
The UK government has since rolled back the vast majority of its planned tax cuts and is planning to introduce other measures to reassure bond markets of its economic policy. There has also been a change at the UK Treasury with Jeremy Hunt replacing Kwasi Kwarteng as Chancellor of the Exchequer. The Bank of England’s measures, which ended on October 14, have returned some stability. Nonetheless the situation has provided a wake-up call for company pension funds.
Calum Mackenzie, investment partner at Aon, discussed the current situation in the UK, its implications for pension funds and what might be ahead.
Calum Mackenzie
Investment Partner at Aon
Could you explain the roots of the issue for pension funds?
Pension funds are very exposed to liability risk, and the risk that changes due to interest rates and inflation affects the value of their liabilities. That affects how much companies need to pay to support their pension funds and the solvency of these funds.
Pension funds have been managing that risk for many years. A lot of these strategies that we're now talking about — the LDI strategies — came into play for most pension funds after the Global Financial Crisis because pension funds did not want to experience the level of risk and deficit increases they were exposed to.
Pension funds have been managing that risk for many years. A lot of these strategies that we're now talking about — the LDI strategies — came into play for most pension funds after the Global Financial Crisis because pension funds did not want to experience the level of risk and deficit increases they were exposed to.
How does LDI work for pension funds?
LDI works by pension funds holding gilts to match their long-dated liabilities. In a perfect world, the pension funds would have the same amount of assets as liabilities and they could hold it all in government bonds — but we don't live in that perfect world. The pension funds need to get some return to close their deficits. So they invest in equities, bonds, property and infrastructure, and to continue to cover all their liabilities, they use some leverage.
This worked well for pension funds during the throes of the COVID-19 pandemic. When COVID-19 hit and the central banks around the world took us into a zero-interest-rate world, the discount rate for pension funds fell through the floor. Their liabilities went sky high and these LDI strategies matched it really well. At that point, the LDI strategies were working so well that they were paying back money to the pension funds that they could either invest in other assets or they could use to reduce their leverage.
Now we’ve entered a period of much greater concern about inflation and much greater concern about rising interest rates. Into 2022, we started to see interest rates and bond yields gradually tick up. We issued a warning to pension plans in June saying that companies needed to be ready for this. They needed to make sure the collateral that supports these leveraged LDI strategies was in place and that they were ready for a rising yield environment. Since then, the market had functioned pretty well, interest rates had been going up in a steady manner, but the liabilities of the pension fund had been going down.
This worked well for pension funds during the throes of the COVID-19 pandemic. When COVID-19 hit and the central banks around the world took us into a zero-interest-rate world, the discount rate for pension funds fell through the floor. Their liabilities went sky high and these LDI strategies matched it really well. At that point, the LDI strategies were working so well that they were paying back money to the pension funds that they could either invest in other assets or they could use to reduce their leverage.
Now we’ve entered a period of much greater concern about inflation and much greater concern about rising interest rates. Into 2022, we started to see interest rates and bond yields gradually tick up. We issued a warning to pension plans in June saying that companies needed to be ready for this. They needed to make sure the collateral that supports these leveraged LDI strategies was in place and that they were ready for a rising yield environment. Since then, the market had functioned pretty well, interest rates had been going up in a steady manner, but the liabilities of the pension fund had been going down.
What happened to cause the crisis for pension funds?
First, on September 21, in response to the cost-of-living crisis, the government capped the unit price on energy bills and basically said that the government will underwrite any difference between where we are now and any future energy bill increases. The chancellor then said that the government would fund that cap through gilt issuance — and the gilt market did not like that.
Then we started to see the pressure on the pound. How do financial markets express their displeasure with our government and with fiscal policy? They do it through the pound or through the foreign exchange market. We saw massive swings in the value of the pound. That’s a big warning sign that markets are getting concerned.
That same week the U.S. Federal Reserve and other global central banks raised interest rates by 75 basis points and the Bank of England raised by 50 basis points. And the market said, “Hang on a second. That’s not a big commitment to inflation. We don’t like that.”
Then, on Friday September 23, the new prime minister and new chancellor announced that they were going to cut taxes — the biggest tax-cutting regime since the 1970s — and that they were going to go for growth. And effectively it's unfunded. The gilt market at this stage starts to sell off significantly.
Then we started to see the pressure on the pound. How do financial markets express their displeasure with our government and with fiscal policy? They do it through the pound or through the foreign exchange market. We saw massive swings in the value of the pound. That’s a big warning sign that markets are getting concerned.
That same week the U.S. Federal Reserve and other global central banks raised interest rates by 75 basis points and the Bank of England raised by 50 basis points. And the market said, “Hang on a second. That’s not a big commitment to inflation. We don’t like that.”
Then, on Friday September 23, the new prime minister and new chancellor announced that they were going to cut taxes — the biggest tax-cutting regime since the 1970s — and that they were going to go for growth. And effectively it's unfunded. The gilt market at this stage starts to sell off significantly.
How did the selloff affect pension funds?
The pension funds collateralize their leveraged hedges with gilts. Suddenly, the actual value of your collateral is falling. You start to see a downward spiral because more and more pension funds are getting calls from their LDI managers seeking more collateral. So they start to sell. And the more the pension funds sell, the more they push down the price.
We were in a downward spiral, a death spiral in effect for the gilt market. At that point, what we were seeing was the gilt market had stopped functioning properly. The movements we've seen in the bond markets were much bigger than the falls in equity markets seen during the Global Financial Crisis and bigger than the fall in price of Bitcoin. And this is the government bond market.
We were in a downward spiral, a death spiral in effect for the gilt market. At that point, what we were seeing was the gilt market had stopped functioning properly. The movements we've seen in the bond markets were much bigger than the falls in equity markets seen during the Global Financial Crisis and bigger than the fall in price of Bitcoin. And this is the government bond market.
Hence, the Bank of England’s intervention?
What we've now seen is the Bank of England saying we have a dual mandate: to control inflation and to maintain market stability and market functioning. And they've put a floor under the gilt market, saying that they would be the buyer of last resort.
What we had was effectively a liquidity crisis because the pension funds have enough money, they're actually well-funded. They've got a lot of assets, they just can’t get the assets into the right place at the right time. The market is not designed to cope with that level of volatility.
Now we have a two-week respite during which the pension plans need to shore up their positions. They need to make sure they’re very strongly collateralized, that they’ve maintained their hedges in place and they’re ready for the Bank of England to remove its support. Big sums of money are being moved around at very short notice.
What we had was effectively a liquidity crisis because the pension funds have enough money, they're actually well-funded. They've got a lot of assets, they just can’t get the assets into the right place at the right time. The market is not designed to cope with that level of volatility.
Now we have a two-week respite during which the pension plans need to shore up their positions. They need to make sure they’re very strongly collateralized, that they’ve maintained their hedges in place and they’re ready for the Bank of England to remove its support. Big sums of money are being moved around at very short notice.
What should UK pension funds do next?
Our advice to clients is use these next two weeks really wisely. First, reassess: review hedging positions to understand whether immediate action is needed to realign with strategic targets. Then, reappraise: while the Bank of England support remains, ensure collateral adequacy is sufficient and strategic targets remain appropriate. Finally, reposition: better decisions need to be made around future management of liability hedges. Interest rate and inflation risks should be balanced alongside collateral risks, as well as consideration of the most robust vehicles to implement the hedges.