Monetary Policy & Inflation | UK
The UK Has a Pension Crisis Not a Fiscal Crisis
- By Bilal Hafeez
- 3 min read
The first rule of crisis management is to know what crisis you are managing. Politicians and the media appear to be framing the recent swings in UK bond yields as signs of a fiscal crisis. It seems simple enough. In September, Prime Minister Liz Truss and Chancellor Kwasi Kwarteng announce a mini-Budget, bond yields surge, and the currency collapses. In October, a new chancellor, Jeremy Hunt, reverses the mini-Budget and bond yields fall. Fiscal crisis averted. But we doubt the issue is over – because the true crisis is not with government finances but those of the pension industry.
The shock of the mini-Budget was not the tax cuts (which were well known) but rather the behaviour of UK pension funds. Thanks to years of engaging in liability driven investment (LDI), pension funds had effectively made leveraged bets that yields would stay low. But in a new era of higher yields, these bets would almost inevitably lose money, and it was only a matter of time before this came to light. The mini-Budget was the spark that lit the pension fire. It revealed UK pension funds lacked the cash to meet collateral calls on their LDI losses. This in turn led to a doom loop: pension funds had to sell their bond holdings to get cash, but this increased bond yields, which required more cash and so on.
This pensions doom loop also explains why the most dramatic interest rate moves have been in UK 30-year bonds. Pension funds dominate the trading activity in these bonds. Were it a typical fiscal crisis, investors would focus on the parts of the yield curve in which the UK government was issuing the most debt. That, in this case, would have been 10-year bonds or less, not the 30-year bond.
Moreover, taken together, we could view the actions of the government and Bank of England since the mini-Budget as averting a pension crisis. The government reversed tax cuts, and the Bank of England bought government bonds to prevent a surge in yields and help protect LDI funds. Meanwhile, the Bank of England’s Temporary Expanded Collateral Repo Facility (TECRF) will help pension funds get cash to meet collateral calls without having to sell assets.
This support was unplanned. The Bank of England’s most recent Financial Stability Report from July discuses household debt risks, corporate debt risks, fiscal policy and bank risks. But it omits pension sector risks. Politicians, meanwhile, have been talking about balancing the fiscal books or boosting structural growth for some time. History tells us that the biggest crises come from where most people least expect it, and the pension crisis did just that.
So, what next? If pension funds are the real crisis point, we must learn what else they have done to boost returns during the earlier era of low interest rates. We know they entered leveraged bets that benefited from low yields. There could be more of these bets that need to be unwound. Already, media reports suggested one LDI fund was teetering on the edge of collapse ahead of Jeremy Hunt’s budget announcement on Monday. We also know that UK pension funds have invested in higher risk and less liquid assets, such as private equity, to juice up returns. These could become the next front in the crisis.
The good news is that higher bond yields will ultimately benefit pension funds as they can secure higher future returns. The bad news is the transition from low yields to high yields will be a bumpy ride.
In the end, though, pension funds, like banks, are so central to society that the government would likely meet any losses. That is when the pension crisis becomes a fiscal crisis. Politicians and central bankers would therefore do well to focus on the risks they dare not name.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.