When chancellor Kwasi Kwarteng announced his Mini budget, few were expecting the sweeping tax changes that were implemented.
It appears that the budget was mini in name only and has immediately had far reaching impact across the entire economy.
UK defined benefit pension schemes have been significantly impacted due to the effect on government bond yields. Government bonds account for around £1.7trn of the UK pension sector. Therefore, when in the aftermath of the mini-budget, gilt yields soared by almost 1.3 percentage points up to 5.06% in just three days, the highest level since 2002, the Bank of England (BofE) felt the need to step in.
Why are government bonds and pensions so intertwined?
Liability driven investing (LDI) is a popular investment strategy for UK pension schemes. LDI involves forecasting future liabilities and investing accordingly in order to reach an outcome where all liabilities are covered - which is the goal for most, if not all, defined benefit pension schemes. LDI strategies are predominantly investments in government bonds and so LDI and gilts frequently go hand in hand.
Why did government bond yields rise and why is that bad for pension schemes?
Despite government bond yields being a steady and popular investment for pension schemes, pensions are usually 'hedged' against large market fluctuations. Essentially, pension schemes which 'hedge their bets' against the market have their liabilities decrease whilst their hedged assets also decrease.
Investments which are hedged against government bonds are subject to 'margin calls' whereby investment brokers require pension schemes to increase their level of cash to maintain LDI leverage levels. For example, brokers may set a minimum level of coverage as a percentage against certain securities or investments.
After the Mini Budget announcement, many brokers triggered their margin calls which required pension schemes to top up their investments on a massive scale. In order to raise funds to do so, pension schemes needed to sell off some of their liquid assets.
To raise money to fund the margin calls, pension schemes sold off their government bonds, which in turn pushed yields higher. This quickly led into an upward spiral, as selling bonds results in greater bond yields, triggered more margin calls on the hedged investments, which caused pension schemes to have to sell more bonds and so on and so forth.
Why did the BofE intervene?
Some banking executives are describing what happened in the aftermath of the Mini Budget as a near miss to a Lehman-Brothers-like collapse in pension schemes, which is why the BoE quickly stepped in.
The bank announced it would purchase up to £65bn of government bonds until 14 October 2022 from the market to improve market stability. By removing bonds from the market, the pressure of increasing yields is removed, which calms the need for brokers to exercise their margin calls on hedged investments to help protect against pension schemes defaulting on their investments.
What should pension scheme trustees do?
In the wake of the Mini Budget, market volatility is far from over. Trustees of pension schemes may wish to consider re-assessing their current investment strategies with their advisors and consider whether de-risking is warranted.
When reviewing a scheme's investment strategy, trustees should refer to their statement of investment principles and The Pensions Regulator (TPR)'s code of practice for funding defined benefit schemes. In particular, trustees should keep in mind that TPR encourages diversification of assets and that trustees are expected to have sufficient and appropriate knowledge to oversee any investment strategy in place with a view to how it will achieve sustainable growth towards its long-term funding objective.
Fiscal events with major effects on pensions are likely to put pension scheme trustees under the microscope. Especially with the draft funding and investment regulations on the horizon which will require trustees to share their investment strategy directly with TPR.
The draft regulations also put an obligation on defined benefit pension schemes to achieve a state of "low dependency" on their supporting employer with a sustainable long-term funding outlook. Exactly what a state of "low dependency" looks like remains to be seen.
TPR will likely expect pension schemes to protect themselves from short-term market downturns via their investment strategy, rather than falling back on further employer contributions. Trustees must, therefore, have adequate safeguarding measures in place to mitigate and 'ride-out' volatile markets.
It's worth noting that the draft regulations and supporting guidance issued thus far do not leave trustees without a lifeline. The Department for Work and Pensions make a clear distinction between "low dependency" and "self-sufficiency", showing that employers will still be expected to contribute to pension shortfalls arising from unpredictable markets.
Paul Ashcroft is an associate and Schuyler Hillbery a trainee solicitor at Wedlake Bell