Page 2 | Can someone explain in laymans terms what is happening with the BOE/pension funds on Friday?

Silverin · 2022-10-11T20:38:46+00:00

There seems to be a lot of panicked talk in the financial media about pension funds potentially collapsing and the BOE needing to step in to help them but this support being stopped on Friday. As a layperson, I would like to understand what is going on - what are gilts, what did the BOE do/not do and what are the risks to pension funds that could cause a collapse on Friday?

Notonthestairs · 11/10/2022 23:36

Well it helped me Bookclub99! 👏
Some great explanations on this thread. I feel better informed if not exactly comforted!

Getofftheladder · 11/10/2022 23:36

Bookclub99 · 11/10/2022 23:31

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

Yes.

so if this goes tits up could people loose their pensions?

Cheeseandlobster · 11/10/2022 23:40

Stupid question but I pay a chunk of my salary into a work pension that I can barely afford. Is it even worth doing this now? I really am struggling to understand all this

VerinMathwin · 11/10/2022 23:41

FiveMins · 11/10/2022 23:19

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.

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

Amarette · 11/10/2022 23:44

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

jtaeapa · 11/10/2022 23:45

There is a pension protection fund that is supposed to pay out if a defined benefit pension scheme can't pay its pensioners. I imagine that is not a bottomless pit though!

BookShark · 11/10/2022 23:59

Another explanation attached (stolen from LinkedIn but hopefully I've managed to crop out any names.

Basically, pension schemes needed money at short notice. A bit like you having plenty of money in a savings account but you can't access it immediately, so you have to sell stuff to get the cash in the short term. That was the panic because everyone was selling at the same time, so prices went down as a result.

DC schemes won't be impacted in the same way, although clearly the FTSE tanking means the value of your savings reduces. But unless you're retiring tomorrow, these should be invested in such a way that they pick up again as the market improves.

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

BookShark · 12/10/2022 00:04

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.

Bookclub99 · 12/10/2022 00:05

Amarette · 11/10/2022 23:44

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

Correct.

BookShark · 12/10/2022 00:12

Oh, and one more reply. Yes, absolutely still worth paying into your pension unless you want to live off the state pension (currently £185 per week) when you retire. Plus contributions will be pre-tax so you wouldn't get the full amount back in cash on a monthly basis anyway. And assuming your employer also contributes, that's even more reason to do so.

I know it's really hard to see the benefit now when you could take the extra cash, but I think we've got a huge pension crisis coming because so many people aren't paying into their pensions - please don't be part of that problem!

MytummydontjigglejiggleItfolds · 12/10/2022 00:12

What I don't understand is why older Gilts are called in etc
Say you had old Gilts with 2% interest, but now the interest rate on new Gilts is 10%, why can't you just keep your old one (that you are still making money on) and buy new ones too?
Then it doesn't cause any of the doom cycles and the people holding the gilts are still making money?

Bookclub99 · 12/10/2022 00:13

BookShark · 12/10/2022 00:04

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.

The issue is the PPF was formed to protect pensioners if the odd pension scheme failed here and there because the employer went bust, not if the whole lot of them needed some kind of bailout. The PPF is only £39B, which wouldn't touch the sides if there were widespread and irrevocable losses. Hopefully it won't come to that.

StatisticallyChallenged · 12/10/2022 00:19

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.

Treesa22 · 12/10/2022 00:24

Bookclub99 · 11/10/2022 23:30

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.

Amazing 🥇

Piglet89 · 12/10/2022 00:26

@Fenella123 great explanation!

Treesa22 · 12/10/2022 00:28