Can someone explain in laymans terms what is happening with the BOE/pension funds on Friday?

Wow. That was a long post. Does it help?

My understanding is that the Conservatives fucked up my chance to easily retire abroad as I was planning to in Greece thanks to Brexit. And now have put mine and DHs very hard earned pensions at risk. Meaning that we will be struggling in old age as we did most of our lives.
All so that their hedge fund friends and the ultra rich make even more money.
This is not thinking about the hell that will play out for vulnerable people.

Am I right in thinking that defined contribution pensions aren't affected by this? Obviously unless it leads to a financial crash etc.

And yes, most DB schemes are eligible for the PPF (pension protection fund) so if the pension scheme fails for any reason (think some recent big name high street store collapses) then you will still get a payout, although it's generally only 90% rather than the full amount.

This is what is happening:

A Gilt is debt issued by the UK. When the Treasury needs to borrow money, it issues a Gilt (effectively an IOU note) to investors. For example, if the Treasury issued a £100 4% coupon 5-year Gilt, it would receive £100 from an investor and give them in exchange an IOU note in which it promised to repay the investor £100 in 5 years time and in the meantime pay them £4 of interest each year. The investor doesn't have to hold the IOU note until the Treasury repays the debt at the end of 5 years. It can sell the IOU note to other investors or buy more IOU notes from yet more investors if it wants to.

For reasons I won't go into here (because it will take ages to explain) defined benefit (aka final salary) pension schemes need to invest the money they will ultimately use to fund their members' pension payments in Gilts. Lots and lots of Gilts. So many, in fact, that they borrowed money to buy those Gilts. For example, if a pension scheme had £100, it went and borrowed an extra £200 and invested £300 in Gilts. Borrowing money to invest in something magnifies gains and losses. In the example given above, if you had invested just the original £100 and your Gilt investment lost 20% of its value you would have lost £20, leaving you with £80. However, if you borrowed £200 and invested £300, then you would have lost £60, leaving you with just £40 once you had paid back the £200 you borrowed.

For yet more reasons I won't go into (because I lack the skill to explain this in layman's terms), when interest rates rise, the price of Gilts falls.

The Bank of England sets interest rates and uses them to control inflation by increasing them when inflation threatens. Because of a mix of Brexit, Covid shutdowns in China and Russia's invasion of Ukraine, there have been supply shortages of certain things (e.g., oil/gas because of the Ukraine thing). This has led to inflation because when things are in short supply their prices increase.The Bank of England has raised interest rates to combat this inflation. This led to the price of Gilts falling. A lot.

Then old Truss/Kwarteng come along and announced a load of tax cuts. Tax cuts are inflationary because people have more money to spend, further driving up the price of those things in short supply.

This meant the Bank of England had to raise interest rates even more. The price of Gilts fell further. A lot further.

Now back to those pension schemes. They are making huge losses on their Gilt holdings. Because they borrowed money to invest in those Gilts, their losses have been magnified, and the people who lent them the money are now demanding they pay it back, so the pension schemes are having to sell Gilts to repay the money, further driving down the price of Gilts... it's a vicious cycle.

To help the pension schemes, the Bank of England offered to step in and buy Gilts. By buying Gilts, the Bank of England drives their price higher, thereby stemming the pension schemes' losses and arresting that vicious cycle. However, the Bank of England really doesn't want to do this. The reason why is because the Bank of England has to print money to buy the Gilts. Money printing is inflationary... so will ultimately drive interest rates higher (to control the inflation), which will force the price of Gilts lower, so the Bank of England has to print more money to buy more Gilts to save the pension schemes... and so on. Another doom loop. That is why the Bank of England put a time limit on buying Gilts - they wanted to do just enough to buy the pension schemes some time to stablise themselves - then stop to avoid the doom loop scenario. That time limit expires this Friday.

People thought the Bank of England might extend the time limit because the pension schemes are still in a huge mess, however the governor has just said that won't happen (presumably because he wants to avoid the doom loop scenario). So now everyone is shitting themselves.

It's all horribly messy. I don't know how this will be fixed, but the only realistic options are: 1) the Bank of England capitulates and starts buying Gilts again (this isn't a good answer because of the doom loop issue), or 2) Truss/Kwarteng reverse all their stupid tax cuts and resign.

If neither of those two things happens some pension schemes may make irrecoverable losses which would mean they wouldn't have enough money to fulfil the promises they made to their members. The only way to fix this would be for the pension scheme employer to put money into the scheme (some won't have enough), for the government to put money into failing schemes (i.e., a bailout) and/or the pension schemes break their promises to their members and don't pay them as much money as they said they would when the members retire - likely a combo of the three.

There are two main types of private pensions- defined benefit and defined contribution. In DB schemes the benefit is fixed (it may vary with inflation or length of service, but there's a specific formula for defining what you get) whereas a DC scheme is basically a pot of cash which you add to and is invested in whatever fund(s) you chose.

This issue is around DB schemes - if your DC investments include gilts or related investments they will have dropped, but the impact is pretty clear and transparent.

For DB schemes, they use an investment approach called LDI - liability driven investment. What this means in theory is that they either want to match the expected cashflows or they wants the value of the assets and liabilities to move in the same way in response to the same factors like interest rates, inflation, etc.

The first - cashflow matching - is easier to explain so I'll use that. Imagine you're a pension scheme and you've commited to pay Bob £1000 a month, every month, until he dies. You have some money/assets, contributed by Bob's employers, to use to make these payments. But how do you manage the money so there's enough to always pay Bob. One option is to buy government bonds which will pay out £1000 per month in income. That means your cash inflows and outflows are matched.
<yes, this is a simplification, don't come at me for ignoring mortality, inflation etc...I know!>

But a lot of pensions schemes aren't well enough funded to do that. They don't have the money to buy bonds which will pay £1000 to Bob and all his mates. Or maybe they do, but they're under pressure to get a better return on investments as bond returns have been very low. So what do they do?

One strategy is to buy the bond and then immediately enter into a derivative contract to short term sell the bond, with a commitment to buy it back at the end. Think of this as the financial equivalent of taking the bond to the pawn shop...

This then gives them an inflow of cash, which can be used to buy more bonds or to invest in something else which gets a higher return.

Where this goes wrong is that the various contracts that are used don't just rely on trust. If you take your diamond ring to the pawn shop and the value of diamonds collapses overnight then you just don't buy it back. With derivatives this isn't possible - the contracts basically say that if the value of the bond moves, one of the participants has to pay money to reflect the change in value so that they can't default easily and the other party is protected. In this case, the value of the gilt goes down - so the person holding the gilt now has an asset worth less than the pension fund has committed to repay and so the pension fund has to pay in extra money to effectively cover the drop in value.

Problem is...they don't necessarily have the cash to meet these margin calls, as they've either invested it in other assets entirely, or they've gone through several rounds of buy - pawn - buy more - pawn, and so are far more exposed to this movement in prices.

This only covers one way of doing it, there's many others, but they all had the same basic issue - need to meet massive margin calls on derivatives which lost value as gilts collapsed. And as people tried to free up cash by selling assets, the situation spiralled.

brilliant statisticallychallenged
One point to highlight - the affected pension funds haven’t been particularly irresponsible or naive. Funding defined benefit pensions is challenging and there are very few financial instruments available out 20 or 30 years away; the way they have done it is pretty established. They have faced a 50% drop in value of these holdings over 4 days which is well outside any standard stress tests and into extreme catastrophe levels; as a business you can’t prepare for all extreme catastrophes, you’d really just have to shut up shop. This will change the risk management approach as people learn from it but don’t blame the pension funds for the crisis or at least without evidence of their risk failings.

Wow. That was a long post. Does it help?

That's not an understanding. That's a completely wrong reading of the situation.

Wow. That was a long post. Does it help?