All looked well in the United Kingdom. The pension system had been underfunded for a long time and now, as interest rates spiked upwards in early 2022, the funding ratio of the system increased to exceed 125%, despite the fact that the market values of investments had been falling throughout the current year. The other side of the balance sheet – the pension liabilities – were discounted by the higher interest rate. As a result, the fall in pension liabilities was greater than the fall in the value of securities. Hence, a moment ago the pension system was in perfect balance.
Suddenly, as if by a strike of lightning, pension investors got into trouble in the UK. They had used derivatives to hedge funding ratios, i.e., the ratio of pension funds to pension liabilities. Now pension funds exceeded liabilities by 25%. Even so, the change in interest rates caused pension investors a liquidity problem akin to that experienced in the financial crisis, when more collateral had to be provided for fixed-income derivatives.
Underlying this development is a strategy known as Liability Driven Investment (LDI). The strategy is to invest by choosing assets that reflect the movement in pension liabilities as closely as possible and generate added value through controlled risk-taking. Over a period of ten years or so, the weight of fixed-income instruments in pension fund portfolios increased at the expense of shares. Fixed-income investments behave just like pension liabilities, i.e., the interest rate affects the two at the same pace, keeping the funding ratio stable. Following this strategy, pension funds and outsourcing partners fine-tune the investment strategy in the derivatives market, thereby enabling them to assume additional risks in order to generate returns. On paper, everything looks just fine.
Central bank fixes the Government’s mistake
On Friday 23 September 2022, UK Prime Minister Liz Truss announced a "mini-budget" promising £45 billion in tax cuts. After all, tax cuts are part and parcel of the Conservatives’ policy, and now Prime Minister Truss is adopting the same old pattern. The response in the market was a knockout blow. Interest rates shot up. The interest rate on the UK 30-year government bond went from 3.7% to around 5% in no time at all. Investors were disappointed and pension investors got into trouble.
There was no lack of whisperers and complainers in the Bank of England offices. And they were heeded. On Wednesday 28 September 2022, the Bank of England announced that it will buy up to £65 billion of long-term government debt securities up to 14 October to curb rising interest rate pressures and falling government bond values. The market reaction was one of delight. The interest rates dropped by more than 1 percentage point in a single day. The interest rate on long-term debt securities fell to 3.8%. This was enough to calm the market.
Derivatives reporting
How big were the problems in the market? The picture is still incomplete, because reporting by pension companies is sketchy, even to the supervisory authority. In 2021, it carried out a survey to determine how to develop reporting by pension communities. The report concluded that derivatives mainly concern pension funds in excess of £1.5 billion and that the relevant stress tests cover this risk. Reporting related to the collateralisation of derivatives was not addressed, and hence calls for increased transparency went unanswered. So, the figures are open to speculation. According to Bloomberg, without the central bank’s intervention, interest rates would have risen by several percentage points and most pension funds would have faced a liquidity crisis.
I recently asked a large Dutch pension investor if they were not worried about rising interest rates. The answer was short and simple: no, it was not a concern. As interest rates increase, the current value of pension liabilities decreases and the funding ratio improves. Again, the main focus is on the funding ratio.
Differences between pension systems
Pension systems differ greatly. In pre-funded and decentralised systems, the focus lies on the funding ratio, the applicable discount factor and return on assets. By contrast, unfunded systems rely primarily on the Government’s or employer’s capacity to deliver.
Equilibrium is also of importance to the Finnish pension system, but it is not disturbed by changes in the discount rate. The discount rate used for pension liabilities is a fixed rate. Consequently, it is the other elements that flex when an equilibrium is sought. Moreover, the Finnish pension system is partly pre-funded; the Finnish Centre for Pensions puts the funding ratio at 25–30%, depending on the discount rate used. Typically, the funding ratio is 21–38% depending on the liabilities profile of the system concerned (TyEL, Keva and VER).
In conclusion
Although the UK pension system was more or less in balance, it came close to triggering a pension bomb. It was about to explode in the derivatives market, affecting those who use hedging instruments. The series of events also demonstrates the vulnerability caused by government debt. The markets no longer tolerated increased government indebtedness, and so the central bank was called in to help. The structure of euro area with one central bank and multiple states sets extra limits for indebtedness. Given the unstable circumstances, the multiplier effects of instability may crop up in unforeseen places.
The writer is VER's CEO Timo Löyttyniemi.
