The mini-budget delivered by Liz Truss and Kwasi Kwarteng has led to the opposite of what was intended.There would have been hopes that the budget would have banished concerns about a looming recession in the UK and to get the economy moving in the right direction.
Yet the number of tax cuts that are seemingly set to go unfunded and the market having a generally dim view of the package served in the budget have made sure this is not the case.
One of the unintended consequences of the mini budget was the impact its implied public borrowing spree would have on pension funds. The UK’s central bank was forced to prop up bond markets (bonds being the way in which the government borrows money) in the aftermath of Kwasi Kwarteng’s budget.
This £65 billion support package is now set to come to an end - something that has spooked the markets yet again.
But why exactly are pension funds at risk - and is there anything you can do to protect your money? Here’s everything you need to know.
What are pension funds?
A pension fund is a financial institution that pools money people go on to use to fund their retirements. In essence, they are the private sector equivalents of sovereign wealth funds.
Pension funds invest the money they hold in a bid to maintain and, ideally, grow the cashpots they sit on. They have nothing to do with state pensions, which are paid for through tax contributions.
Defined contribution pensions
These pots are based on how much money is paid into them. They are either arranged by your employer, or - if you’re self-employed - by yourself.
What you pay in is invested, with the size of your retirement pot dependent on how much you’ve put into them, how well these investments have performed, and how you withdraw it. Pension funds typically take a small percentage out of your pot as a management fee.
Defined benefit pensions
Sometimes known as ‘final salary’ or ‘career average’ schemes, these pensions are usually arranged by your employer. What you get depends on things like your salary, how long you’ve worked for the company, and what the fund’s rules are. For example, you may not be able to take your pension until you reach a certain age.
Where do pension funds invest money?
Pension funds invest money in several different ways. In the UK, most investments usually come in the form of shares and government bonds.
Government bonds - also known as gilts - tend to be popular investments for funds because they provide a predictable income stream (typically once or twice a year) and the UK government has traditionally held a good credit rating, making its debt a low-risk investment.
For funds specialising in defined benefit pension schemes, government bonds are also helpful because many of them last for a 20 to 30 year period. This longevity tends to allow the funds to match their assets with their liabilities.
Put simply, the money (assets) invested in these bonds usually grows at a rate that will allow the fund to pay out cash to pensioners at the rate they were promised (liabilities).
Liabilities can grow if those expecting a pension are on large incomes and live to an old age. Inflation and interest rates also have a bearing on the size of liabilities. The former grows liabilities, while the latter makes them smaller.
Why did the Bank of England intervene?
The Bank of England was forced to step in to prop up the bonds market after the mini budget. The fall in the pound, fears over interest rate rises and concerns about how much money the government would need to borrow to fund its tax cuts almost led to a run on pension funds.
Defined benefit pension funds were at the centre of the storm, particularly those using what are called Liability Driven Investments (LDIs).
Put very simply, these are insurance policies against changing liabilities. In more usual times, these allow pension funds to magnify their assets and free up cash for extra investments in exchange for a small amount of money that typically goes to banks. The money they have to put up grows with interest rates.
Explaining why LDIs have become an issue, Sarah Coles, a senior personal finance analyst at asset management company Hargreaves Lansdown, told NationalWorld: “As interest rates have risen [in 2022], [funds] have already had to put up more cash. But they increased slowly enough to give them time to sell other assets sensibly to cover it.
“The overnight collapse of bond values gave them no time. They were forced to sell bonds to cover the extra cost, depressing the price of bonds even more and creating a vicious circle.”