By Finn Watson

After the UK’s private pension system nearly collapsed during the LDI crisis, continued failure to support the needs of retirees, and widespread cuts in pension benefits leading to strikes, perhaps a re-examination is required. 

The UK pension system was designed to provide a comfortable retirement by providing a guaranteed and adequate income accessible in one’s golden years. There are multiple parts of the pension system. The state pension, started in 1908, is a guaranteed income given by the government to people of retirement age that depends on one’s national insurance contribution (NICs) as well as other factors. This pension is special due to its universality – it is given to everyone regardless of their financial position – and has a ‘triple lock guarantee’ that is designed to insulate the pension against inflation by raising the payments by either a 2.5% annual increase, the rate of CPI growth, or the change in average earnings, whichever of the three is greatest. However, the full state pension is inadequate for the average Briton coming in at only £185.15 per week, a figure completely detached from the current cost of living. In fact, the OECD found that the UK ‘pension replacement rate,’ or the degree to which a state’s pension payments replace the average salary from work, was at a measly 21.6%. This number is much lower compared to the OECD average of 42% and much like other Anglo-saxon countries such as the US and Canada, the UK places a high value on individual responsibility. In this way, the insufficiency of the state pension is meant to be offset by individual savings and private pensions that are earned through employment. However, with the 2022 LDI crisis along with the resulting cuts to future benefits adding fuel to the strikes, the confidence in private pension by their beneficiaries is at an all-time low. 

The unassuming and frequently overlooked pension funds were one of the central players in the seizure of the gilt market in September 2022 following Lizz Truss’ ‘mini’-budget. The crisis was facilitated by ‘liability driven investing,’ or LDI for short, which is a strategy which started to gain popularity in the early 2000s as a way to hedge against risks from inflation and interest rate changes. This strategy was employed by ‘defined benefit’ (DB) pension funds which are plans that offer retirement income based on length of employment and other factors. Unlike defined contribution (DC) funds, such as the US’ 401(k), where both the employer and employees make contributions, the DB plans are purely employer funded. The DB schemes then take the employer contributions and invest them into capital markets, making sure that there are enough assets to meet the net present value of liabilities owed to the employees when their retirement matures. However, to act as a bulwark against interest rate and inflation volatility, the LDI managers employ leveraged hedges that include repurchase agreements as well as derivative products such as interest rate swaps. This frees funds that can then be invested in higher return assets such as equity and property to fund the deficit of payments. Such a proposition was attractive to many pension managers, many of whom were facing large deficits, and so leveraged LDI was widely implemented in the UK.

The crisis was kickstarted with the ‘mini’-budget that included £45 billion of unfunded and inflationary tax cuts while the BoE was simultaneously raising the base rate in an attempt to lower inflation. It was an overall mess that sent bond yields rocketing and prices tumbling. These fluctuations in the bond market were many standard deviations above the expected volatility employed in the risk models of LDI managers. Thereafter, the pension schemes that utilised leveraged financial products in their LDI strategy were met with margin calls that quickly became difficult to meet. What followed was a massive selling off of £28 billion in gilts which squeezed liquidity from the gilt market further heightening the yields and derivative losses. This self-reinforcing liquidity crisis may have turned into a solvency crisis were it not for the BoE who started buying bonds in an attempt to restore liquidity instead of their previously planned anti-inflation bond sell off.

Is it better now? Partially, yes. While the value of assets has fallen dramatically, liabilities have fallen further due to the higher discount rate so many of these schemes have actually rebounded into surplus. Since the crisis ended, much of the discussion has focused on who’s to blame and whether it was because of the mini-budget, pension schemes, consulting groups, regulators, clearinghouses, or some combination of these things. But regardless of who’s to blame, not only has the pension system threatened its own security – along with the retirement incomes of their beneficiaries – but this spiral actively accelerated the deterioration of the gilt market and GBP. In this way, the pension system now represents a larger systemic risk to the financial market than was previously known and the whole ordeal does not particularly inspire confidence. In December, the Work and Pensions Committee (WPC) met to discuss the crisis and allowed the LDI to continue albeit with more conservative guidance on liquidity buffers. Additionally, the popularity of private DB schemes were declining even before the crisis and since LDI was a specific tool of DB schemes to control risk while funding their deficits, it’s likely that the crisis will accelerate the transition to DC. This is ultimately dissapointing to many current and future  employees who see DB schemes as more generous because of the guaranteed income and higher average payouts. 

However, the LDI crisis is just the tip of the iceberg of discontent. For example, the current strikes that university students across the UK are currently witnessing – the largest to ever affect universities – are largely motivated by pension cuts. Initiated in April 2022, the cuts included a 35% decrease in pension income upon retirement as well as significant reductions in the inflation adjustment rates. With pension changes that significant, it’s understandable why many are striking. On top of that, after rebounding into surplus after the crisis, a repeal of the cuts could be funded by the pension schemes without moving into deficit. However, the regulatory authority has limited changes to DB schemes due to the LDI crisis and several high profile  bankruptcies of companies such as Carillion with similar pensions. It’s indicative of the state of pensions that students and staff within one of the best higher education systems will be worse off  because of the failure to come to stable and fair agreements surrounding pensions and pay. 

It’s not just universities that face heightened labour disputes over pensions. From accusations that NHS pension rules have intensified the NHS staffing shortage, to the failure of many small firms to match employee contributions due to financial trouble, there is a simmering disaffection for pensions across many sectors of the economy. Clearly, there is room to improve the system and to better the financial position of many in the UK.

One possible avenue of improvement are so-called collective defined contribution plans (CDCs) such as those used to great effect by Canada, Denmark, and the Netherlands. What is different about these pensions and is anything preventing the UK from achieving similar results? CDC plans pool employers and employee contributions to a collective ‘pot’ that pays a retirement income that is guaranteed until death (like a DB plan) but this payment depends on the return of the portfolio (like a DC plan). CDCs also have a distinct advantage over DCs by mitigating ‘longevity risk’ where the individual may die before spending all their pension, or outlive their pension and be left without income. This is possible because the CDC manages assets based on the average age of the members. According to analysts, if the UK followed a pension model similar to those of Canada, Denmark, or The Netherlands, the expected increase in retirement income would be at least 30% higher. Such plans have recently been adopted by the Royal Mail and other entities in the UK. 

However, CDCs have many detractors. Criticism of these plans focus on the increased risk that facilitates the higher returns. Compared with DB and DC portfolios that usually rely on the safety of bonds, CDCs have portfolios consisting almost 100% in equity and therefore assume more risk. In many ways, this would be acceptable to the majority of pensioners, however, the recent LDI crisis does not inspire faith in the ability of fund managers to accurately assess and mitigate risks. Furthermore, critics claim that in a DC you are free to choose the risk profile that’s right for you but CDCs deprive employees of this input. In this way, CDC implementation would have to be accompanied with clear communication of the risks and an understanding between the managers and beneficiaries. Overall, the higher returns of CDCs promise to improve upon the status quo and optimism towards these schemes is increasing. It appears that CDC plans could be the future of UK pensions and the groundwork for further adoption has already been established. However, it will take some time before we know if CDC is the best modification to fix current pension problems.

It’s clear from the LDI crisis to the current strikes that the pension system is not doing enough for the UK and its future and that close cooperation between the government and the financial sector is required to mend these issues.

The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.

Photo by Mathieu Stern via unsplash.com