UK PENSION FUND CRISIS

                   

Indians have been programmed to have at least one pension fund in their portfolio, since the day they start working. Parents encourage their children to work for the government and then enjoy the pensions. That's why products like NPS are famous in India. Definitely, the pensions continue to help many individuals who have either suffered some financial losses or have lost the sole earner. But one question that always strikes me whenever I see any LIC poster or NPS related ads in the newspaper is, are the pensions really safe? Well, I wish the citizens of the UK had asked this question before investing. 

A few days ago, some news broke out which probably stopped the heartbeat of the citizens of the UK. The news stated how the pension fund crisis in the UK has contributed to the financial crisis that is currently going on in the UK. More than 30 million British nationals invest in pension funds. The crisis was so bad that the then government led by Mrs. Truss had to present an emergency budget to stop the collapse of the pension fund. What was the crisis? How bad was it? Let's look at it. 

Before we dive into the main saga, let's take a look at some basics.

1. Bonds are a form of debt instrument which are issued by governments as well as by corporates to raise money and against which, a certain percentage of interest rate is offered. Bonds are a favorable source because (speaking only about India) corporate loans have interest payments as high as 12%. Also, investors are in a constant hunt for an instrument where they can park their money. Bonds offer as low as 3-4% returns to as high as 9-12%. So, it's a win-win situation for investors as well as the organizations that are raising money, as investors get steady and constant repayments and organizations get cheaper loans. 

2. Bonds offer yields. Meaning, the rate of return on a bond guarantee is called yield. Bonds are tradeable instruments and hence trade on the exchange. The bond prices and interest rates have a negative correlation (one goes up, the other one comes down). 

3. When markets fall, usually investors tend to park their money in the bond market. Interest rates are fixed on the bonds and hence, when bond prices rise, interest rates change. 

4. The yield curve is the difference between the rates offered by bonds of different maturities. Bonds have different maturity years, ranging from as low as 2 years to as long as 40 years. When investors buy short term bonds, it is interpreted as investors are expecting a short fall in the markets and are hence becoming pessimistic. When investors start buying long-term bonds, it is interpreted as investors believe the markets are going to crash, badly. 2 year and 10year bond is considered as the best example for this activity. When investors start buying long-term bonds than short-term bonds, then the yield curve widens and vice-versa. 

5. Margin calls are a form of additional deposit demanded by the broker to cover your losses. If I buy Reliance using derivatives and expect that the share would flourish and exactly the opposite takes place. At this time, the broker would call me and would ask me to refill the loss amount, or he would sell my position at a heavy loss. To carry my position, I will have to pay the margin call. 

6. LDI system - liability driven investments - The main goal of LDI is to make sure that the pension funds have enough money so as to pay their retirees in times of crisis. Since retirements are 30-40 years in the future, these pension funds buy long-dated bonds. If my pension payments are Rs 5 then I should at least have Rs 8 in my account. That's the LDI system. 

7 Sucking out liquidity - when governments offer bonds to investors, they are taking out liquidity by collecting the money from us and giving us bonds instead. When governments want to take bonds back, they offer us cash in exchange for those bonds. This is how liquidity is maintained. 

Now coming back to the UK pension fund crisis. 

The bond market of the UK was in chaos as investors were leaving the UK markets because of recession fears (NOTE: UK is in recession officially). Since there was a lot of pound outflow, the pound crashed. It fell to an all-time low against the dollar. The UK pension fund were the largest holder of government bonds with more than 50% of their investments parked in Glits (UK government bonds).  

Pension funds usually invest for the long term in government securities, which yield a steady and safe return, so as to compensate pensioners, but with rising inflation and constantly increasing interest rates, yields on the bonds started increasing. The returns went from bad to worse. The pension funds had long positions in these bonds. Meaning, they were betting that the bond market would do well, but I guess luck wasn't supporting the setting sun on the UK. The pension fund houses started getting margin calls. The pension funds were in urgent need of liquidity. The problem was, they held almost 50% of government bonds and domestic as well as foreign investors were selling those bonds. Hence, they were trapped. The pound fell to the lowest level in history. 

The government had to save these pension funds as they were the backbone of the British economy. The day when the Pound fell, then President. Liss truss announced a mini budget which acted as gasoline on fire. The move was sudden and huge. The Bank of England (central bank of the UK) was asked to intervene in the situation and was also asked to conduct a bond buyback programme. The pension funds were on ventilator. 

The process entailing offering collateral started. When the yields rise rapidly, more collateral is to be offered as what is known as a "margin call". If bond yields rise slowly, then it doesn't hurt pension funds to rely on LDIs. The pension fund faced a margin call for $1.88 billion. The pension funds weren't able to raise this much amount on a short term basis without dumping assets. Everyone started selling and there were no buyers. Since everyone was selling, the yields kept rising, which led to more margin calls and this circle continued. The Bank of England stepped in and bought a whopping $76 billion worth of bonds in an effort to stop the "self-reinforcing spiral" and "widespread financial instability". Around 400 funds faced a margin call. Since the central banks around the world are increasing interest rates, people started opting for a cash position and this added friction to execution of trades. The intervention saved the pension fund houses from tasting mud. 

It is said that the Bank of England has added $1.17 trillion on their balance sheet. Meaning, they have bought bonds worth $1.17 trillion. Lessons from the following crisis: 

1. Even pension funds can fail. Hence, our money is never safe. 

2. Even high IQ guys can screw up, so drop the perception that people with high IQ never fail. 

3. Government policies play a key role. Here, the Bank of England has brought back $76 billion worth of bonds. The question to ask is, how did the BOE arrange to allocate this sum? Has currency printing taken place? 

4. The way in which your government manages a crisis is very important. It all started with Brexit and then the Covid and then President Boris Johnson and Liss Truss and their policies. 

Who knows what's next for the Brits. Also, the UK is officially in a recession, so the future would be worth watching. It' time for the sun to set maybe.