On 15 September 2022, Chancellor Kwasi Kwarteng introduced a mini budget that the markets reacted to with significant negative volatility. As a result, there was coverage in the media suggesting that pension funds were at risk due to the sudden rise in interest rates and dramatic changes in bond markets.
We're pleased to be able to reassure you that the Fund has not suffered any adverse effects from this recent market turmoil. We're also happy to give you the following reassurances:
- The Fund has remained more than fully funded throughout this period and has a large surplus
- Its funding position strengthened in the days following the mini budget
- The Fund has no issues with investment liquidity
- The security of your benefits has not been challenged at all
The period following the mini budget has been difficult for pension schemes that rely heavily on an investment approach known as Liability Driven Investment (LDI). The problems did not affect the Fund because it does not use LDI as part of its investment strategy.
What is LDI and why has it caused problems?
LDI is an investment arrangement that a pension fund can make with a financial institution. It aims to ensure that the value of the fund is closer to the amount of assets needed to match the benefits it will need to pay out to members and their beneficiaries. LDI can protect the fund against interest-rate risk and inflation risk and help stabilise the funding level.
In essence:
- If market conditions threaten to reduce the funding rate, the financial institution supports the pension fund so that it can still meet its liabilities.
- If market conditions increase the funding rate, the pension fund makes collateral available to the financial institution.
In effect, the pension fund gains protection against any down-side of market movements but gives up the availability of any gains from any up-side of market movements. This keeps the scheme's funding level more stable than it would have been.
LDI strategies are often geared so that the levels of what is protected or given up can be a multiple of the amounts invested in the LDI strategy.
LDI and gilts – the link
Generally, pension schemes calculate the value of their liabilities by discounting all the future benefits to a current value using a discount rate derived from gilt yields. Gilts are basically loans made to the government on which the government pays a fixed monthly amount and returns the capital value at the end of the term. Gilt yields are the percentage returns an investor can get when buying gilts for whatever rate they're valued at on the open market. When gilt yields go up, scheme liabilities go down and so funding levels improve.
In the recent turmoil, gilt yields went up dramatically and suddenly, and to an extent that went beyond the usual stress tests schemes carry out. This rise in yields improved pension schemes' funding levels. As a consequence, pension schemes using LDI were then obliged to make very large payments at short notice to the financial institutions supporting them. Some did not have enough liquid assets to meet their binding requirements in time. Many could meet the requirements only by a mass-selling of gilts, which would have made the crisis in gilt markets even worse.
Less than a week after the chancellor announced his mini budget, the Bank of England stepped in to stabilise the gilt markets by indicating its willingness to buy gilts up to a limit of £65 billion. This avoided the liquidity challenge facing pension funds using LDI getting worse.
The Fund was not using an LDI strategy and so was unaffected. The Trustee has considered using an LDI arrangement in the past, although not to the extent that liquidity of assets would have been a problem in this instance, but decided not to.
Further information
This is a simplified explanation of a very complex financial arrangement. You can find out more about LDI in An introduction to Liability Driven Investment – a booklet produced by Insight Investments.