Is my pension safe? This is a question that is going to be on the lips of many a jittery client over the next few months and enough to give many an adviser/paraplanner a hard time trying to reassure them. The Brand Financial Training team examine recent events and how pensions may be affected.
In the immediate aftermath of the mini-budget announced by Prime Minister Liz Truss and Chancellor Kwasi Kwarteng on Friday 23 September, markets were, to put it bluntly, chaotic. This culminated in the unprecedented decision of the Bank of England to use £65 billion of its currency reserves to purchase UK government bonds in order to stabilise prices and prevent a number of pension funds experiencing serious liquidity issues.
The question this put on pension holders’ lips was ‘could my pension fund really fail?’.
So what was the problem and why did it arise? Initially, there was a negative reaction to the mini-budget from the markets as a whole caused by concern at the absence of a full forecast from the Office for Budget Responsibility, high levels of borrowing and the lack of a clear funding strategy. This resulted in a mass sell-off of government bonds as investors deemed UK government investment a less desirable option and new investors demanded higher rates of interest to buy them. This, in turn, resulted in the secondary market values of existing gilts, whose coupon payments (i.e. the periodic interest payable) are fixed and determined at outset plummeting.
How does this impact the security of a client’s pension? For those with defined contribution schemes, the impact is likely to be limited, but will depend on the investment strategy. The investments to be held within a pension fund are chosen by the member and can range from a simple default fund to a number of self-selected funds. Direct investment into government securities is also permitted, though it would be rare in practice that a private individual would actually hold them. However, many pension funds hold gilts as part of the investment strategy, particularly those which use the lifestyling option to automatically switch into (allegedly) less risky assets in the run-up to retirement.
The key point with these schemes is that it is the scheme member who takes the risk. Therefore, whilst the value of the fund is likely to fall, this does not mean that the entire scheme is at risk. It should also be noted that, whilst their value on the secondary market can fluctuate, ultimately, if they are held to maturity, gilts will always repay their par value, i.e. the amount originally invested.
For those with annuities, their pension will not generally be at risk. Purchasing an annuity means that the pension pot is exchanged for an undertaking from the insurer to pay an income for life on terms fixed at outset. Whilst it is usual for annuity providers to hold a significant element of fixed interest holdings in order to match liabilities, the risk in terms of investment strategy and market movements is borne by the provider. In the event of provider default, annuities are protected by the Financial Services Compensation Scheme. In general, annuities are considered contracts of long-term insurance. Therefore, the amount protected would be 100% of the insured amount (i.e. the agreed payment) with no upper limit.
The real issue here lay with defined benefit (DB) pension schemes. Like annuity providers, the sponsoring employer is obligated to pay scheme members an income for life. This leads to many funds employing an approach known as liability-driven investing. In summary, what this means is that the investment strategy is dictated by the timescale within which the funds are required. For funds earmarked to pay existing pensions, very secure assets are usually used, such as gilts or investment grade corporate bonds.
Some pension schemes use complex derivatives as part of their investment strategy in order to hedge against falls in interest rates. The downside to this is that where interest rates rise, the pension fund can end up owing money to the counterparty. Depending on the terms of the contract, this can mean that they are required to make what are known as margin payments in order to provide security against the debt. The significant increase in demands for such payments meant these schemes were required to sell other holdings, including more gilts, in order to do so.
In essence, what happened was that a fall in the value of gilts threatened to lead to a ‘cycle of doom’ where pension funds were forced to sell more of their gilt holdings than expected in order to meet liabilities. This forced selling and lack of willing buyers, in turn, drove the prices down further and further, effectively creating a run on the gilt.
Now the good news. Firstly, it is important to note that this was largely a liquidity issue. Gilts held until maturity will always return their par value. In the long run, increasing yields on gilts and other fixed-interest securities are generally a good thing for defined benefit pension schemes, as they reduce the value of the assets required to pay the scheme’s liabilities and reduce funding deficits. For some schemes, it may result in a significant surplus. It was the speed at which the scenario unfolded which left some schemes unprepared and led to the Bank of England’s emergency intervention.
Further, UK DB schemes are protected by the Pension Protection Fund (PPF) and following the decision in Hughes versus the Board of the PPF, the cap is in the process of being removed. This means that members of a DB scheme whose sponsoring employer was to become insolvent will generally receive a minimum of 90% of their accrued entitlement without any upper limit. In other words, whilst the member may suffer a financial shock as a result, in the vast majority of cases, it is not likely to be an insurmountable one. As we have also seen in recent days, the Bank of England is also willing to intervene in order to support the value of government bonds where it is deemed necessary.
A side-effect of the significant rise in interest rates and gilt yields over the last few months is that DB transfer values are plummeting. Essentially, this is because gilt yields are usually used to calculate the capital value of the member’s scheme pension entitlement. As a basic explanation for those not familiar with transfer value calculations, if interest rates were 2.5% then a capital sum of £200,000 would get you £5,000 per annum in interest payments (£200,000 @ 2.5%). However, if interest rates were then to rise to 5%, suddenly, you would only need £100,000 to get your £5,000 (£100,000 @ 5%) annual interest payment. This is the concept at the heart of transfer value calculations. It is simply carried out in reverse, as we start with the annual income and then use this to calculate the capital value rather than vice-vera.
As of July 2022, the XPS Transfer Value Index, which tracks the average transfer value of a DB entitlement in the UK, was down around 25% from the figure at the end of 2021 (£203,000 against £270,000). All of which is likely to make DB transfers less attractive and encourage members to value the security of their DB scheme in these uncertain times.
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[Main image: Jason Dent Unsplash}
