UK update: The risk of de-risking: making sense of the mini-budget’s impact on pensions

It will not have escaped anyone’s notice that the past 10 days have been a bit of a roller coaster in UK financial markets.

The government’s mini-budget on 23 September raised concerns about inflation, and sparked a fall in the pound and an increase in gilt yields (broadly, the return on government bonds). Given the market turmoil and investor reaction to the situation, the Bank of England stepped into calm things down and said it would purchase long dated gilts in order to avert a looming crisis. Much of the discussion centred on the impact of all of this on pension funds, with sensationalist headlines about pension schemes going bust. Was that really a risk?

The three biggest financial risks faced by pension schemes are inflation, interest rates and longevity (i.e. how long people will live once they start receiving their pensions). Most pension schemes have invested in funds that hedge the inflation and interest rate risk for their scheme by investing in government gilts of varying durations. The benefit of these investment products is that the scheme’s investments track (to a greater or lesser extent) their liabilities. So even if assets “plummet”, liabilities fall by a similar amount leaving the overall funding position of the pension scheme in balance and avoiding the risk of a shortfall for pension payouts to members.

The issue for many pension schemes last week was that as gilt yields rose, investment managers were asking for additional cash collateral to back those investments (in order to maintain levels of protection against the risk of interest rates and inflation changes). And with many schemes (encouraged for years by the regulatory authorities and the dwindling number of members in defined benefit pension schemes across the UK) invested in low risk and less liquid assets, funding those substantial cash calls was a real challenge for some. The forced sale of assets to release cash in a market where the value of those assets has fallen is never an attractive proposition and contributes to a downward spiral. Hence the Bank of England action as pension schemes faced the prospect of selling “safe” government gilts to fund those collateral calls.

Relative calm has been restored, for now. But what happens next? I certainly never expected front page headlines about the recklessness of pension schemes investing in government bonds!

As pension schemes have de-risked in order to better match the benefits they have to pay out to members, government bonds have been their safe haven. Most pension schemes will now start revisiting their investment strategy and looking closely at their asset allocation. Could we now see a re-risking of pension schemes’ investments, essentially reversing what has been a decades’ long move towards de-risking? If we see pension schemes invest more in equities, will that help fund the growth that the UK government is desperately seeking? And how will the Pensions Regulator react given its focus on pension schemes eliminating risk and reaching a position where they are not dependent on the sponsoring employer? Or do we just have to accept that dealing with market turmoil is part and parcel of any investment strategy and there will always be weeks like last week and then things will stabilise, we will regroup and investment strategies will adapt? These are all questions that trustees and employers should be asking of their investment consultant now that calm has been restored (for now).

You can read our article on auto-enrolment below:

UK Update: Time for an auto-enrolment health-check?

By Burness Paull LLP, Scotland, a Transatlantic Law International Affiliated Firm.  

For further information or for any assistance please contact ukscotland@transatlanticlaw.com

Disclaimer: Transatlantic Law International Limited is a UK registered limited liability company providing international business and legal solutions through its own resources and the expertise of over 105 affiliated independent law firms in over 95 countries worldwide. This article is for background information only and provided in the context of the applicable law when published and does not constitute legal advice and cannot be relied on as such for any matter. Legal advice may be provided subject to the retention of Transatlantic Law International Limited’s services and its governing terms and conditions of service. Transatlantic Law International Limited, based at 42 Brook Street, London W1K 5DB, United Kingdom, is registered with Companies House, Reg Nr. 361484, with its registered address at 83 Cambridge Street, London SW1V 4PS, United Kingdom.