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The writer is co-founder of Ondra Partners
It is beyond ironic that an investment strategy that claimed to eliminate risk threatened the unprecedented failure of the UK pension system this week.
The main focus of attention so far in probing what went wrong has been on what took place over the few days leading up to the Bank of England’s emergency intervention on Wednesday to stem a crisis in pension funds over so-called liability driven investment strategies.
These strategies aim to hedge the liabilities of funds to meet their pension promises with the use of derivatives. But they suddenly exposed the sector to a now infamous “doom loop”, when falls in gilt prices triggered calls on schemes to provide more collateral on such trades, in turn spurring more sales of UK government bonds to raise cash.
However, the origins of the crisis stretch back more than 25 years when some of the current government’s members were still in secondary school. Starting in the late 1990s, a series of tax and regulatory changes made the provision of defined benefit pensions by companies to their employees so onerous that, by and large, companies closed their funds to new members.
Such schemes typically promised workers a retirement income that was a multiple of their years of service. The closure to new members of the vast majority of these schemes would lead to seismic — and completely foreseeable — implications for the UK economy and financial system over the following two decades. It led to a profound change in the way funds would be managed because of the compound interaction of two factors.
First, the funds now had a finite time horizon, servicing only existing members, and were therefore no longer indefinite intergenerational savings vehicles. Rather, they had become more akin to annuities and would need to be managed as such. For example, their now foreshortened time horizons made it harder to recover from the impact of poor investments, which significantly curtailed their appetite for risk.
Second, corporate sponsors’ risk profiles were asymmetric — companies were on the hook for all of the funds’ deficits and losses but had no practical access to any upside surplus until the last pensioner had died. So they behaved completely rationally to support pension trustees in their quest to eliminate all risk.
These two factors, combined with the increase in longevity, has had devastating consequences for the entire UK economy ever since. The recent meltdown is just an inevitable culmination of those earlier decisions.
The pursuit of zero risk led to a massive and permanent change in pension funds’ asset allocation — the proportion of their funds invested in bonds increased from less than 20 per cent in 2000 to 72 per cent in 2021. The Investments in listed UK equities declined steadily, from 50 per cent of their asset allocation in 2000 to 4 per cent in 2021.
For all practical purposes, defined benefit pension funds have ceased to supply long-term equity capital to invest in the growth of UK companies. The reservoir of equity capital built up by these funds over generations has been mostly drained.
This has reduced funding for homegrown centres of research and innovation while rendering critical infrastructure and much of the country’s technology and defence sectors dependent on foreign companies or private equity for capital.
Tragically, we have ended up with an emasculated system that is unintentionally self-destructive and, as this week has shown, still remains vulnerable. If anything good is to come out of this latest crisis, it is hopefully a recognition that, rather than a few tweaks here and there, we must now change this system root and branch, once and for all.
The UK government should as a matter of urgency commission an official inquiry into both how the nation’s pension savings system could have been put at such extreme risk and what steps need to be taken to ensure that this can never be allowed to happen again.
We now need to put in place a new, longer-term and more resilient savings system, better matched to the long-term interests and global competitiveness of the real economy. We need a pension system that is more inclusive of all generations and especially one that can supply long term risk capital to support the economic growth ambitions to which our new government is committed.
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