In light of discussions in the media at present around government bonds and challenges faced by pension funds, I wanted to write this bulletin explaining more.
What has happened?
The Bank of England has been raising interest rates to try to curb inflation, which has been the biggest problem faced by the UK economy.
Rates have been increasing quite quickly, and to levels not seen for over a decade. However, these rate rises have been clearly signposted, giving financial markets, businesses, and consumers, a good indication of what’s coming. As a result, financial markets have been remarkably resilient so far, despite the headwinds.
The measures Liz Truss announced to help provide support with energy bills were also taken calmly by markets. They were deemed necessary and were debt-funded, likely to cause the UK’s economy (and thus tax revenue) to contract substantially less over the coming winter.
Kwasi Kwarteng’s mini budget however, announced a raft of additional tax cuts and stimulus, that came as a surprise, with no evidence of how they would be funded. The government failed to provide a detailed analysis of what this would mean for the UK economy, nor did they outline how they would rebalance the books and return to a path of fiscal prudence.
This resulted in sharp drops in UK government bond values. Government bonds are investment securities that are held by private and institutional investors, in the UK, and all around the world. Whilst not immune to fluctuations, over the long term they usually deliver low returns and low volatility. As a result, they often make up the more secure elements of investment portfolios. This makes them especially popular with final salary (also know as ‘defined benefit’) pension funds, which use them extensively both for investment, and to pay pensions to their retired members.
This sudden and unexpected downdraft in government bonds, usually a relatively predictable and safe investment, caused liquidity problems for some of these final salary pension funds. In response to this sudden move in government bonds, the Bank of England stepped in. One of their key roles, alongside controlling inflation, is to ensure the security of the UK financial system, acting as the ‘lender of last resort’. They created a special support measure to temporarily buy up government bonds from pension funds that needed help, to give them liquidity and time to sell down some of their investments to boost their cash reserves.
This short-term relief measure is scheduled to come to an end on Friday and there are concerns that it does not give enough time for some pension funds to rebalance their books. Some rumours suggest the program may yet be extended, though Andrew Bailey, governor of the Bank of England, has publically stated that pension funds “have...days left...to get this done”. Whether this comes to pass or not, the Bank of England has announced that it will provide further support beyond the deadline in other ways, though we don’t yet know the details.
What does this mean for your pension portfolio?
The pensions that we manage for you, take the form of personal pensions. We manage each one in line with your personal goals, timelines and feelings about risk. These portfolios invest in different kinds of securities, spread all around the world. This is what is known as diversification and it is used to help spread risk. Tatton, our investment partners, build these portfolios for us and deal with the day-to-day management of the investments, making decisions about what to invest in and when. They regularly report back to us and we keep an ongoing dialogue with them, monitoring performance closely.
Ahead of the events we’re currently seeing in UK government bond markets, Tatton had already been reducing exposure to these assets throughout the year. This means that at the time of writing, they represent only a small part of portfolios overall, so we have little direct exposure to UK government bonds. Pension portfolios are still volatile at present however, as global stock markets are moving around a lot at the moment. We’ve seen some large swings in value this year and in the past two months, values have fallen back for now. However, as I often say, this is just a normal part of stock market investing. Sometimes the path is all smooth sailing, sometimes things get bumpy, but longer term, every storm passes in time.
So, you can rest assured that the pensions we manage on your behalf have little exposure to UK government bonds. The kind of pensions that are under pressure at present due to their exposure to these assets, are final salary pensions, otherwise known as ‘defined benefit’ pensions.
How does this affect final salary pension funds?
Final salary pensions, work in a different way to personal pensions. When you are a member of a final salary pension, for each year that you pay into the scheme whilst you are employed, you accrue the right to a future income stream. This often includes a tax-free lump sum, payable when you reach the scheme’s retirement age.
The employer is responsible for meeting these future liabilities to pay member pensions. To do so, they pool together member pension contributions into a large fund, held in trust, which they invest. Their goal is to invest the money and manage their fund, so that they can pay member pensions when they reach retirement.
Like all investments, the portfolios that these pension funds hold rise and fall in value over time. This can lead to the scheme being either in ‘surplus’, or ‘deficit’. Surplus is when there is enough in the pot to cover all liabilities, with room to spare. Deficit is where there is a shortfall. If a pension fund falls into deficit, they must put a recovery plan in place, to show how they will get back on track. This includes the employer making extra contributions if required.
Most final salary pensions sit in the public sector. If these schemes become underfunded and fall into deficit, the shortfall is usually topped up by the taxpayer. Some final salary pensions remain in the private sector however. These were closed to new members many years ago, but some remain in ‘run off’. This means they still have members that accrued benefits in the past, who have not yet retired. When they do, these companies will need to use their pension funds to pay their pensions. It is these private pension funds that are the biggest cause of concern at present. If they fall into deficit due to the current situation, the sponsoring employer could be forced to make additional contributions. If they can’t afford to do so, this could push some businesses into financial difficulties.
If I have a final salary pension, how am I protected?
In the rare event that a pension fund falls so deeply into deficit that they cannot recover and it looks as though the employer may become insolvent, there are support measures in place to help protect their members. The Penson Protection Fund (a.k.a ‘PPF’) was setup by the government for this exact purpose.
If the sponsoring employer fails, the PPF will compensate you for 100% of your pension if you’ve already reached the scheme’s retirement age and are receiving your pension.
If you haven’t yet reached the scheme’s retirement age, the PPF will ensure that 90% of the pension you had accrued when the sponsoring employer went bust, will be paid when you come to retire. There is a compensation cap that depends on your age and which is currently under review.
Conclusion
For now, we simply must wait and see how this plays out. The Bank of England has already acted decisively. By Friday we should know whether they will extend their current support program or put a different kind of support measure in place, to support government bond markets and pension funds.
If you are a final salary pension member, you are protected by the PPF. For those of us with personal pensions, we have very little direct exposure to government bonds, but we must continue to ride out the current financial storm. Whether it’s an external shock (such as Covid), or a cyclical economic downturn (current inflationary pressures), such events, whilst different, are all part of the usual order of things when it comes to stock market investments.
It’s easy to forget how many big ‘uh-oh’ moments we have had to deal with along the way, but almost every year there is something major that rocks markets and sends the media into a tailspin. Stock markets have had to work through difficult periods like this since the very beginning and will continue to do so.
To illustrate this, I’ll close with a useful chart that may provide some reassurance. Entitled ‘climbing the wall of worry’, it shows the long-term performance of world equity markets over the past 30 years, labelling the many challenges that have been faced along the way. I guarantee that some will jog your memory when you read them. Whilst no doubt a cause for concern at the time, it’s amazing how quickly we put these things behind us and move forwards.
Rest assured that we’re keeping the current situation under close observation and Tatton are continuing to position portfolios in the best way possible to navigate the current challenges in markets.
If you have questions or concerns, as always, please feel free to get in touch.
