UK pensions: What is happening and how will it affect us?

The UK pension business is in deep trouble. You would suspect that it must be in trouble if Jacob Rees Mogg, the business secretary, has to deny that pensions are at risk. And you know it must be in trouble if the Bank of England has to step into the markets to rescue them.

What has happened is that the market gyrations of the past few weeks have exposed weaknesses in the way the pension funds have invested their money, and these weaknesses come on top of wider falls in asset prices. The problems can be fixed, but we don’t yet know how much that will cost – and the money to do so will ultimately come from people saving for their pensions.

First, a bit of background, then what is happening in the markets, then what this means for pensions.

In the private sector, there are two totally different sorts of pensions. There are the so-called “defined benefits” aka “final salary” schemes, where the pension is set in relation to the person’s earnings and contributions rather than the value of the pension pot. And there are “defined contributions” or “pay-as-you-go” schemes, where the size of the pension is determined by the amount of money put into the pot by employee and employer and how well it has been invested.

The government’s most recent figures show that 28 per cent of people with workplace pensions are on defined benefit schemes, 29 per cent on defined contribution ones, and the remaining 21 per cent have some sort of personal pension. Then there are 21 per cent who don’t have a workplace pension at all. Over the past 30 years, employers have switched from defined benefit to defined contribution schemes, so in practice, older people are likely to be in the first group, while the young will be in the second.

If your pension is defined contribution or you have a personal pot that you pay directly into, what matters is the size of that pot. You carry the risk, not your employer. That pot will probably have gone down this year. The FTSE 100 index of large UK companies is down nearly 9 per cent this year, and if you think that is bad, the S&P 500 index of US companies is down 25 per cent.

But over the years, if dividends and interest are reinvested the pot will grow. Over the decade to the end of 2021, UK equities produced an annual return in real terms (ie, allowing for inflation) of 4.7 per cent. US equities did even better, with an annual return of 12.5 per cent. Barclays, for example, has a study of its customers going back more than a century charting this.

For defined benefit pension funds, where the provider of the pension carries the risk, the problem is much worse. Providers have been very aware of the need to protect themselves against swings in the equity markets and have switched the balance of their investments into bonds, mostly government-issued ones (in the UK dubbed “gilts” because years ago the paper certificates of these bonds had gold edges).

Historically, bonds have been more stable than equities, and because they are deemed less risky pension regulations are framed in such a way as to push pension funds into them. The trouble is that they give lower returns. Over the 10 years to the end of 2021 gilts gave only a 1 per cent annual real return. So pension funds were encouraged to find other ways of increasing the yield, which basically involved borrowing against the security of their gilt holdings to buy other financial contracts. This is called a liability-driven investment (LDI) strategy, and if you don’t understand what that means you are in good company. It seems likely that most pension fund trustees didn’t either.

In normal times these LDI strategies seem to have worked all right. But the increases in interest rates this year, and in particular the rise in government bond yields, have destroyed them. In January the yield on 10-year gilts was below 1 per cent. This week it went above 4.6 per cent, though by Thursday it had fallen to around 4.3 per cent. True, this rise was partly the result of a loss of confidence in the new UK government, and Liz Truss and Kwasi Kwarteng bear considerable responsibility for that. But it is not entirely their fault, for all bond yields have risen sharply. The US equivalent, 10-year treasuries, have gone from 1.5 per cent in January to over 4 per cent now.

Bond prices move inversely to bond yields – the interest rate is fixed, so if the price of a bond halves, then a holder gets double the interest rate. This year, looking at government bonds overall, has been the fourth worse since 1700. Bank of America’s research unit did some sums on this, showing that a typical portfolio had fallen by more than a quarter by the end of September, and the only bigger falls had come after the South Sea Bubble in 1721, after the US Civil War in 1865, and after the First World War in 1920.

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What happened in the past three weeks is that the plunge in gilt prices meant that the pension funds not only lost money on their holdings but since they had also borrowed against them, they had to sell gilts to cover the margin on those loans. The more they sold, the lower the price – creating a doom loop that the Bank of England had to break by buying gilts to steady the market. This emergency action will, the governor Andrew Bailey says, end on Friday – though given the turmoil, maybe it will have to carry on. Put gently, he has not communicated very well, as my colleague Sean O’Grady comments here.

So what happens next?

There will be a blame game, and it is hard at this stage to apportion blame fairly. It also seems inevitable that some big pension funds will need to be rescued. There is a body called the Pension Protection Fund which was set up to pay “compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer and where there are insufficient assets in the pension scheme to cover Pension Protection Fund levels of compensation”.

All pension funds have to subscribe to it, and quite aside from the questionable principle that it isn’t fair to punish the whole class when there is one naughty pupil, there may not be enough money to cover the losses. But while we don’t yet know how bad this is, we know it will be a rough time ahead. So yes, Mr Mogg, we do need to worry about pensions.