Leverage in UK pensions revealed by mini-budget

UK pension funds have long been encumbered with long-term obligations: managing long-run inflation expectations, while, thanks to advances in longevity, also dealing with the fact that pensions need to be paid for longer.

These are known challenges for pension funds.

However, there are wider issues. These are leverage issues which were largely hidden from view until those funds came under severe strain following a dramatic rise in interest rates on long-dated UK government bonds in the days after the calamitous UK mini-budget on 23 September.

In an interview with journalists Paul Sweeney and Matt Miller on Bloomberg Markets AM (Thursday 20 October 2022) Professor Richard Portes teased out the principal issues concerning liability-driven investments in UK pension funds.

Sweeney and Miller asked Professor Portes, ‘has the crisis passed’?

“We’re not over the crisis yet. Those funds affected by the crisis still need to liquidate significant parts of their portfolios concerning liability investments, or special purpose vehicles (SPVs) as they more properly might be known, in memory of the global financial crisis. That’s what they are, they’re separate but at the same time joined at the hip to the main pension funds,” said Portes.

UK pension funds had historically “loaded up” on long-term government bonds. “A perfectly sensible move,” said Portes. “Pension funds need bonds because they have long-term liabilities. However, the bonds weren’t yielding anything, so what do you do? You ‘repo’ them; you get cash in exchange for those bonds and then you buy high yielding assets, or you take out derivative exposures. While I won’t go into the kind of hedging you can do with those measures, it amounts to more less the same thing: it frees you up to take more lucrative investment possibilities.”

‘But also more risk?’ “Yes,” observed Portes, “but it shows up on your books as assets that have the same kind of duration as your long term liabilities as a pension fund. The problem is that if the prices of those underlying government bonds go down, the lenders, or the markets will require you to post collateral to meet margin calls. What these funds then encountered following the miin-budget was a big spike in government bond yields - a big fall in government bond prices in the UK.”

The result of this short-lived period, said Portes, was this large spike which nobody had provided for and no safeguards had been made. “Nobody realised the extent of the underlying issues, and when this happened they had to meet margin calls and they had to liquidate their government bonds.”

The result of this activity was more pressure on government bond prices and more upward pressure on the yields for those bonds “They still have a lot of those bonds and they’re still liquidating them and getting the cash in, although in a more orderly way than immediately in the aftermath of the mini-budget as the bond markets have now calmed down to a degree.”

Now that this seemingly risky investment strategy has been uncovered, and acknowledging that one had never thought to look into UK pensions before, nor of the existence of ‘black box derivatives’, what do these pension funds do moving forward? ‘Are they facing long-term obligations at a rate they cannot possibly fund?’

Surprising, no. This is because, said Portes, the fund’s obligations are not rising. “With the rise in interest rates the discount rate that they applied to their liabilities, which are after all long term - paying out pensions to people when they get to retirement - the discount rate on those liabilities rises and so the present rise in interests rates, both leading up to and beyond the mini budget and the subsequent bond market crisis, proves to be great for the balance sheets for the pension funds.”

In sum, pension funds are, in aggregate, back in surplus overall when compared to a very weak situation for these funds a year or two ago. “So that at least is a big plus,” said Portes.

“On the hand, the big negative is that no one realised what was going on with these pension funds. The regulators hadn’t a clue, which points to a bigger problem. There’s a lot of hidden stuff out there in terms of leverage and hidden exposure. Even if the regulators were up to the job, they don’t have the data in many cases to grasp nor adequately interrogate the situation.”