With recent announcements of the pound falling, government borrowing increasing, emergency support ceasing and general concern over the UK’s financial stability, many might be worried about what is happening to their pension. Despite the alarming headlines and turbulent situation, pension industry experts are reassuring the public their pensions are safe and not to panic.
Stuart Price, Partner and Pension Actuary at independent financial services consultancy Quantum Advisory, gives his thoughts:
The news we are hearing every day about market fluctuations and a steep fall in government bond prices is obviously concerning, however, individuals should be reassured their pensions are very strongly protected and perhaps the news is not as bad as people have been led to believe.
What has happened?
Government bonds, known as gilts, are normally safe investments and are prevalently used by British pension funds. This is particularly the case for defined benefit or final salary schemes as they offer more protection against falls in interest rates and increases to long term inflation expectations. The government’s mini budget at the end of September hit confidence in these gilts which led to a sell-off and investors started demanding a higher rate of interest to buy them. The Bank of England (BoE) stepped in to temporarily buy more gilts to stabilise the markets.
Are all pensions affected?
The first thing to know is there are two main types of pension schemes; defined benefit (DB) schemes, sometimes known as final salary schemes and defined contribution (DC) schemes. DB schemes pay a pension to members based on their service and salary whilst in the scheme. Contributions are paid by members and the scheme’s sponsoring employer which are invested in one common fund that is used to pay members’ pensions when they reach retirement.
There are lots of protections in place for members of DB schemes. In the worst-case scenario where the employer backing the DB scheme goes bust and the pension fund does not have enough assets to pay the pensions promised to members now and in the future, the Pension Protection Fund (PPF) will protect members’ pensions. For those already retired, in most circumstances they will continue to receive 100% of their pension, and for those yet to retire, they will receive 90% with future increase for all likely to be lower.
DC schemes, which are now the most common type of pension scheme in the UK, act more like a savings account whereby the member and employer contributions are ringfenced into individual accounts and invested to give the member a pot of money that can be used to provide them with an income when they retire. The amount of money the member will receive is dependent upon the amount of contributions paid and the investment performance of the DC scheme.
How are current events impacting DC pensions?
DC schemes seldom invest in government bonds and if they do, exposure to these investments are general low, so members in DC scheme generally should not see too much of an impact.
Any falls DC schemes do see in their value, should be short-term, but pensions are of course a long-term investment. The economy goes through cycles of highs and lows, so if you are in a DC scheme and are many years away from retiring, be patient and wait for this to dip out. On the plus side, for those contributing to their DC scheme, the current lower market values will actually increase the amount of assets purchased by those contributions.
If you are nearing retirement and are in a DC scheme, the amount you hold in government bonds might be higher than members further away from retirement and you might see more of a drop in the value of your DC scheme. On the positive side, the fall in government bonds is likely lead to improved annuity rates so those about to retire and purchase an annuity (pension) may find that they can achieve a higher pension than they would have otherwise. Therefore, it is fair to say that if you are close to your retirement you need to carefully consider which actions to take as, whatever you decide, will impact the amount of income you receive. In these circumstances, speak to your pension provider in the first instance to check the options available to you.
How are current events impacting DB pensions?
DB schemes have been impacted much more by the fall in government bond prices. Many of these schemes hold large amounts of government bonds to provide them with protection against falls in interest rates and increases to long term inflation expectations, so the assets in these DB schemes will have fallen.
The situation is compounded further by DB schemes that hold Liability Driven Investments (LDI). Like government bonds, these investments allow DB schemes to have protection against falls in interest rates and increases to long term inflation expectations, but the schemes physically need to hold less assets than government bonds for the same level of protection. This then allows DB schemes to invest in growth-seeking assets such as equities to help keep the costs of funding DB schemes at a manageable level for the sponsoring employer.
Recently, because of the fall in government bond prices, the value of these LDI funds also fell and to ensure that the DB scheme retained the same level of interest rate and inflation protection, schemes had to sell other assets and pass these monies (called collateral) to the LDI investment managers. Given the big drop in government bond prices over a very short period, and the fact that it can take days or weeks to disinvest funds to provide cash, many DB schemes struggled to meet the LDI investment managers’ requests at such short notice. It should be noted that these DB schemes weren’t at risk of collapsing, it just meant the amount of interest rate and inflation protection that the DB scheme had was reduced while the cash calls from the LDI managers were trying to be met.
Ultimately, the BoE’s bond-buying intervention helped stop the fall and stabilise government bond prices and hence reduce these cash calls. Without this intervention, and if cash had not been paid to the LDI funds by pension schemes, then the value of their LDI investments could have fallen to zero.
What is happening now?
The government, with their new Chancellor in place, has reversed most of the decisions made in September’s mini budget. This has helped to stabilise markets even further. However, government bond prices are still low compared to where they were before the mini budget. When government bond prices are low, the yield (or interest payment) investors will receive from government bonds increases. When government bond yields increase then the calculation used by pension actuaries like me to place a value of the DB pension promised to members (called liabilities) falls. So bizarrely, what this means is that despite all these worrying headlines, for many DB schemes, even though the value of their assets has fallen during the last month, the value of their liabilities has fallen even further and therefore their funding positions are now stronger. Confusing, but of course very good news to DB scheme members.