MPs are heaping pressure on the Pensions Regulator over its support for risky investment strategies that nearly pushed the industry to the brink last week.
The work and pensions committee has written to the watchdog amid concerns that it approved of, and may have even encouraged, the use of popular hedging contracts that magnified the market turmoil caused by the government’s mini-budget and resulted in a £65bn emergency support package by the Bank of England.
The committee’s chair, Sir Stephen Timms, asked the regulator whether it had done enough to monitor the risks posed to pension funds, given it appeared to play down reports that the schemes were coming under pressure back in August.
He also asked whether the watchdog should have taken “stronger action” before the central bank was forced to step in to avert a pensions crisis last Wednesday.
“Many people – including members of defined benefit pension schemes and sponsoring employers – will have been extremely concerned to read about the impact on pension funds of the fall in the price of long-dated government bonds last week,” Timms said in the letter addressed to the Pensions Regulator’s chief executive, Charles Counsell.
He said that while the Bank’s intervention “appeared to ease the pressure on schemes, there remains concern at what might happen when this intervention ends on 14 October”.
The intervention came after a plunge in the pound and a collapse in UK bond prices last week forced pensions funds into a firesale of assets in order to meet collateral calls on hedging contracts, known as liability-driven investments or LDIs.
Monetary policy
The job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%.
Fiscal policy
The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. 'Fiscal easing' is when plans for tax cuts not are not matched by planned spending cuts.
Budget deficit
The gap between what the government spends and its tax revenues
Government debt
The sum of annual budget deficits – and the less frequent surpluses – over time.
Government bonds
In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.
Bond yields and prices
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.
Short- and long-term interest rates
Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.
Quantitative easing and quantitative tightening
When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply through sales of assets.
Pension funds and the bond markets
Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. A rapid drop in gilt prices can threaten to make these hedges ineffective.
Margin calls
Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly.
Doom loop
This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. If pension funds are selling gilts into a falling market, the result is lower gilt prices, higher gilt yields, bigger losses and further margin calls.
Fiscal dominance
This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts.
Larry Elliott Economics editor
However, those firesales further depressed prices, subsequently triggering larger collateral calls that prompted fears of a “doom loop” that threatened to drain pension funds of their assets, until the Bank stepped in.
LDIs have been widely used by mostly final-salary pension funds managing more than £1.5tn in savings to help hedge against risks in the value of their investments.
But some critics claim that those contracts have actually introduced risks into the system, including through increased leverage – where funds borrow money to invest – and collateral calls on those financial contracts.
Even the government’s £39bn “lifeboat” scheme for private company pensions, the Pension Protection Fund, was forced to come up with an extra £1.6bn in cash to cover collateral calls on its own LDI contracts last week, it emerged on Wednesday.
The Pensions Regulator has been accused of actively encouraging the use of LDIs, with some saying the watchdog even threatened trustees that were too cautious or refused to deploy hedging contracts that they might put retirement money at risk.
“Few pension schemes are culpable. In the main, they were cajoled and even threatened if they resisted adopting these strategies,” said Con Keating, a pensions expert and chair of the bond commission of the European Federation of Financial Analysts Societies.
Keating said the effect of the Pensions Regulator’s approach to LDIs was evident when comparing private and public pension schemes. Local government pension schemes, which are not overseen by the regulator, rarely use LDIs.
The watchdog’s formal guidance states that trustees “may wish to consider” the use of LDIs to manage interest and inflation risks within their schemes. It notes that that “LDI introduces some additional risks, eg around leverage and collateral management, and trustees should understand these and take appropriate steps to manage them.”
However, the committee’s letter highlighted a blogpost from the Pensions Regulator that appeared to play down concerns from affected pension firms this summer.
“Anecdotally, we hear that some schemes may have been underprepared, after years of falling interest rates in which LDI funds were paying collateral back to schemes,” the regulator said in August. “But we know that advisers were making trustees aware of the risks, and our DB investment guidance covers it too … We remain vigilant to the risks and expect trustees to do the same.”
The Pensions Regulator declined to comment on the committee letter but said it would respond in due course.
