The UK pension fund crisis shows that there is no capitalism without capital or risk

The author is co-founder of Ondra Partners

Ironically, an investment strategy that purported to eliminate risk threatened the unprecedented failure of Britain’s pension system this week.

So far, the focus of the investigation into the failures has been events in the few days leading up to the Bank of England’s emergency intervention on Wednesday to stem a crisis in pension funds over so-called liability-driven investment strategies.

These strategies aim to hedge funds’ obligations to meet their pension commitments through the use of derivatives. But they suddenly exposed the sector to a now infamous ‘doom loop’ as the drop in gilt prices triggered demands for schemes to post more collateral for such trades, which in turn prompted more sales of UK government bonds to raise cash.

However, the origins of the crisis go back more than 25 years, when some of the current members of the government were still in secondary school. Beginning in the late 1990s, a series of tax and regulatory changes made corporate provision of defined benefit pensions to their employees so onerous that corporations largely closed their funds to new members.

Such schemes typically promised workers a retirement income many times their years of service. Closing the vast majority of these systems to new members would result in seismic – and entirely predictable – repercussions for the UK economy and financial system over the next two decades. Due to the compound interaction of two factors, this led to a profound change in the way funds were managed.

First, the funds now had a limited time horizon, only serviced existing members and were therefore no longer unlimited intergenerational savings vehicles. Rather, they have become more like annuities and must be managed as such. For example, their now-shortened time horizons made it more difficult to recover from the impact of bad investments, which severely limited their risk appetite.

Second, the risk profiles of the corporate sponsors were asymmetric – the companies were hooked for all of the funds’ deficits and losses, but had no practical access to an upward surplus until the last retiree died. So they acted rationally to support the pension administrators in their efforts to eliminate all risk.

These two factors, combined with the increase in longevity, have since had a devastating impact on the UK economy as a whole. The recent meltdown is just an inevitable culmination of those earlier decisions.

The quest for zero risk led to a massive and lasting shift in pension fund asset allocation – the proportion of their funds invested in bonds rose from less than 20% in 2000 to 72% in 2021. Investments in UK listed equities declined steadily, from 50 percent of their asset allocation in 2000 to 4 percent in 2021.

For practical reasons, defined benefit pension funds have stopped providing long-term equity to invest in the growth of UK companies. The equity reservoir built up by these funds over generations has largely been used up.

This has reduced funding for domestic research and innovation centers, while making critical infrastructure and much of the country’s technology and defense sectors dependent on foreign companies or private capital for capital.

Tragically, what we end up with is an emasculated system that is unintentionally self-destructive and, as this week has shown, still remains vulnerable. Hopefully, if anything good is to come out of this recent crisis, it’s the recognition that we need to change this system once and for all, rather than making a few tweaks here and there.

The UK government should urgently launch an official inquiry into how the country’s pension savings system has been placed at such extreme risk and what steps need to be taken to ensure this never happens again.

We must now adopt a new, longer-term and more resilient savings regime that is better aligned with the long-term interests and global competitiveness of the real economy. We need a pension system that is more inclusive of all generations and, most importantly, one that can provide long-term venture capital to support the economic growth ambitions to which our new government is committed.

https://www.ft.com/content/f4f78487-0e9d-4dea-afe7-425b11e83a4d The UK pension fund crisis shows that there is no capitalism without capital or risk

Adam Bradshaw

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