5 October 2022 Pension Crisis Averted

Pension Crisis Averted​

What do you need to know this week?

Following the government’s “mini-budget” announcement on Friday 23 September, the market reacted rather adversely (to put it mildly). Last week, we looked at the impact the announcement had on the pound. Shortly after we published last week’s newsletter, news broke of yet another resultant crisis-in-waiting — this time in the pensions market.

The government’s announcement drove down the price of short-term UK government bonds (“gilts”) down as investors baulked at what amounted to fiscal expansion (tax cuts) in a time of monetary contraction (interest rate rises)*. As pension funds tend to hold much of their assets in gilts (because the gilt market is traditionally considered secure), the pension funds were acutely exposed.

In order to stabilise the situation and ensure that pension funds would remain solvent and pay their liabilities to members as they came due, the Bank of England intervened by promising to buy £65bn worth of gilts over the next two weeks, which stabilised the price of the bonds (because the market now knew there would be a guaranteed buyer even if the price dropped).

Why is this important for your interviews?

Pension funds are among the largest class of institutional investors. Workers entrust pension funds to manage their contributions so that when they retire, they have enough money to live on. As pension funds collectively manage trillions of pounds worth of money, the fund managers ultimately rely on investment managers like BlackRock to advise them on where best to invest the cash to generate adequate returns.

One of the largest challenges pension funds face is balancing the need to:

1. maintain short-term liquidity; against the need to:
2. generate long-term returns.

This is because, in the case of (1), the funds must have enough cash on hand to pay members eligible to draw from their pension. But having too much cash on hand means that the funds are not adequately investing the rest of the beneficiaries’ money in such a way that beats inflation (i.e.(2)).

To get around this contradiction, in the early 2000s, investment banks created new products known as “liability-driven investments” (LDIs). In essence, LDIs are contracts between funds and banks that hedge the pension funds’ exposure to short-term market volatility among the asset classes pension funds are exposed to, including gilts. In exchange for pensions promising to provide counter-parties (e.g. investment banks) a portion of collateral, the LDI contracts will guarantee the value of short-term assets (e.g. gilts) when market volatility drives their price down.

Following the government announcement and the cratering price of gilts, counter-parties demanded more collateral payments (“margin calls”) at an unprecedented rate. Without the Bank of England’s intervention, regulators and investors feared that pension funds would become insolvent — i.e. unable to meet their current liabilities.

How is this topic relevant to law firms?

Given the role pension funds play in the market, law firms advise pension fund managers and investment funds managing pension money on the pension funds’ behalf. No doubt, this acute shock to the pension market will spur stakeholders into action to minimise the impact of any future liquidity crisis.

Hogan Lovells, Linklaters, Allen & Overy, and CMS are among the most highly regarded law firms that advise pension funds and associated stakeholders.

*This is a simplification, as the price of any bond including gilts is directly dependent on their yield (i.e. the return on investment), which itself depends on the interest rate.