The UK pension fund crisis should be a cautionary tale

Bank of England Governor Andrew Bailey is said to have once fallen asleep over a pensions scandal during a meeting in 2019 when he was heading Britain’s market watchdog. The question now is whether the BoE and other regulators were sleeping at the wheel when the pension fund near crash ensued after Kwasi Kwarteng’s “mini” budget.

Last week’s incident – triggered by a huge surge in gilt yields that triggered margin calls for defined benefit pension funds that use derivatives to hedge risk – has shed light on a dark corner of finance. Like other crisis areas, it is poorly understood despite its impact on people’s life savings. It is a country fraught with imbalances of power, conflict and activity between regulators. Despite warnings, deficiencies have not been remedied for years.

The episode should also be studied amid broader market turmoil. High inflation and interest rate hikes, particularly by the US Federal Reserve, have exposed strategies based on long-term low interest rates. There will undoubtedly be more eruptions.

The near implosion of what should be one of the safest markets raises uncomfortable questions about its oversight. In the UK, the BoE protects overall financial stability. The Pensions Regulatory Authority oversees workplace pension schemes and the Financial Conduct Authority regulates wealth managers such as BlackRock and Legal & General Investment Management. These companies bundle the investments of pension funds, including through so-called liability-driven investment strategies at the heart of the crisis. This strategy of helping pension schemes meet their obligations was not only supported by their regulator but actively encouraged. It worked well for 20 years – until it stopped working.

The chief of Next previously warned the central bank about the “time bomb” for financial stability in the LDI market. The BoE itself has flashed Systemic risks of the strategy in 2018 but little was done to mitigate them.

Although the Pensions Regulator oversees the funding and risk management of schemes, it does not regularly collect market-wide data on collateral levels and leverage. It is up to LDI managers to agree their leverage (some has been up to seven times) and collateral with individual clients – often small and non-skilled. LDI funds’ liquidity management is framed by broad EU-originated principles rather than strict rules. Wealth managers effectively set the rules of the game but are its dominant players. This needs to be checked by the regulators.

Another lesson learned from the financial crisis is the importance of rigorous, mandatory stress tests that have consequences for failure. While many pension funds stress test their models, the tests are not set by the regulator and are not rigorous enough.

The tests are often conducted by investment advisers who act as gatekeepers to hundreds of billions of pounds in pension fund money, but their services remain unregulated in the UK. They advise trustees – whose competence the watchdog has questioned – on where to allocate funds and which wealth manager to select. Her role most recently emerged during a market crisis following the Brexit referendum. The Treasury promised to consider giving the FCA oversight of investment adviser services. It should be doing more than brooding now.

The original sin lies with a prime minister and chancellor who poured oil on volatile markets with an unfunded financial report that promised huge tax cuts. Regulation could never completely shield funds from the unleashed turmoil. Unfortunately, with a government that prioritizes growth at all costs and cuts in bureaucracy, the short-term chances for sensible guard rails seem slim. The UK pension fund crisis should be a cautionary tale

Adam Bradshaw

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