The Great British Pension Fiasco
The Great British Pension Fiasco unearths the uncomfortable truth about the very institutions entrusted with safeguarding the UK’s financial stability. This is a tale of the failed governance that paved the road to more austerity, stalling the green transition and gutting social investment.
It is hard to imagine that we live in the same Britain that birthed Keynes - the man credited for the economic theories that convinced a war-ravaged nation to spend its way out of austerity while building the NHS on a mountain of government debt more than twice as high as today’s relative to GDP. It is hard to believe that this is the same Britain that housed its working class in council homes while still paying off Hitler’s bill. Liz Truss, like a gardener who waters only the tallest trees, declared her tax cuts would make the forest thrive. But roots starved of rain grow desperate, while the canopy hoards the light. Sooner or later, even oaks topple when the soil beneath them turns to dust. Her version of “growth” became the wind that felled the grove.
Despite the misguided tax cuts for the wealthy, the country continues to pay the price for the misattribution of what really caused the downfall of the Truss Government. The media continues with a false narrative, and our leaders hyperventilate over fiscal “black holes” smaller than a 1940s budget typo in real terms. They have replaced Beveridge’s blueprint with dogma reminiscent of the Victorian age, swapped targets for social housing and the green transition for imagined targets in spreadsheet cells based flawed and highly inaccurate forecasts, and our academia treats Keynes like a problematic uncle best forgotten at the family reunion. One might ask: Did the political class fail history class? Or is this collective amnesia sponsored by the same corporate lobbyists who have turned “public service” into a euphemism for “private profit”?
In the annals of financial disasters, the UK's 2022 gilt market meltdown will go down as a classic tale of regulatory negligence, conflicts of interest, and political intrigue. Forget what you have heard about Liz Truss's ill-fated mini-budget being the prime culprit. The real villain in this story is an institution supposed to be above reproach: the Bank of England, and the story's roots stretch back to well-intentioned but naively flawed regulatory decisions nearly two decades prior.
Seeds are sown
Our tale begins in the hallowed halls of Westminster, circa 2004. Lawmakers, eager to shield British workers from corporate pension failures, passed legislation aimed at making pensions safer.1 On paper, it sounded impeccable; a secure retirement for all. But in finance, the devil is always in the details. This law, coupled with new accounting rules,2 made pension funds hyper-sensitive to short-term market fluctuations. Essentially, every market hiccup demanded an urgent response from pension funds, leading to a scramble for stability. Imagine if every time the stock market went down, you had to put more money in your savings account. That is what happened to pension funds being required to account for pension liabilities on the balance sheets of corporate employers and then requiring that gains and losses be marked to market with strict recovery plans when market valuation of pensions fall below the fully-funded thresholds.3
Fuelled by the EU’s Institutions of Occupational Retirement Provision (IORP) Directive in 2005,4 the financial wizards entered with their solution: Liability-Driven Investment strategies, or LDI. This financial alchemy promised to match assets with future pension payments through complex derivatives. The accounting standards led to a focus on short-term financial stability due to the immediate impact of market fluctuations on the balance sheet. This focus often came at the expense of long-term investment strategies that might have been more beneficial for pension schemes in the long run. Instead of volatile equity exposure, long-term defined benefit liabilities were matched by increasing the use of financial derivatives known as interest rate swaps, inflation swaps and gilt repurchase agreements (repos), which served to match long-term pension outflow obligations with fixed long-term interest inflows. In financial terminology, the pension funds increased duration of their assets to reduce the volatility of their balance sheet exposure to the mark-to-market accounting standards.
Initially, it seemed like a brilliant approach. However, as interest rates remained low, pension funds got greedy. LDI was no longer just about reducing risk; it became a tool to juice returns, leading to significant hidden leverage within the system. The regulatory framework from 2005 onwards permitted pension funds to use these derivatives and repos not only to manage their liabilities but also to increase leverage to enhance returns. Derivatives, such as interest rate swaps and inflation swaps, enabled pension funds to synthetically match the duration of their liabilities with their investment holdings without directly holding the underlying assets. The exposure was unfunded because the pension funds only needed to put up a margin for collateral to maintain this exposure with their counterparties. This unfunded exposure to synthetic fixed income freed up cash to buy higher-yielding illiquid corporate bonds, private equity, and infrastructure assets.
The volatility introduced by the mark-to-market approach of FRS17 at first prompted pension funds to adopt these Liability-Driven Investment (LDI) strategies to match liabilities, but as prolonged quantitative easing lowered long-term yields on fixed income assets, LDIs were increasingly being used as a tool for leverage, despite the ban on borrowing. These strategies use leverage to hedge against interest rate and inflation risks but also expose funds to liquidity risks during market stress. In two years following the 2005 IORP Directive, pension funds increased exposure to interest rate swaps by £50bn.5 By 2020, UK pension funds had a staggering £1.5 trillion invested in these LDI strategies – over half the size of the entire UK economy, teetering on the edge of financial engineering that few comprehended.6
Global pandemic, supply chain breakdown, and inflation
Fast forward to September 2022. Inflation is rising, interest rates are climbing, and pension funds using LDI are feeling the squeeze. Then comes Liz Truss's mini budget, proposing £45 billion in unfunded tax cuts. The market reacts badly, and gilt yields start to spike. Suddenly, pension funds are caught in a vicious cycle of selling assets to meet margin calls, threatening to crash the entire UK bond market. The details, however, reveal a sequence of events that point to a different culprit than Liz Truss’s mini budget for the collapse in gilts that ensued.
Quantitative tightening and signs of stress in private pensions
In the aftermath of the global pandemic, the Bank of England joined global central banks in raising interest rates and reversing the quantitative easing policy with periodic selling of the long-term securities that were accumulated during the post-GFC period. The new Bank of England quantitative tightening policy increased the supply of long-term gilts on the market at a time when the Treasury had already increased the supply of gilts to deal with the pandemic. This caused a precipitous drop in gilt prices, thereby increasing long-term yields.
On 17 March 2022, the Bank of England raises interest rates from 0.5% to 0.75%. On 21 March 2022, the first voices of concern about LDI strategies were published by industry leader in risk management, Hymans Robertson:
If rates continue to rise and inflation stabilises, or even falls, this is likely to be a double whammy tailwind for funding but also put collateral pools under increasing pressure. Trustees of DB schemes should therefore use this time to stress test their collateral pool to ensure that there is an acceptable level of resilience and inform early warning indicators for further action… Contingency plans should then be put in place to ensure there isn’t the need for a forced sale of non-LDI assets or a forced unwinding of hedging positions to balance the books and meet scheme expenditure obligations.7
On 1 July 2022, reports of margin calls begin to surface in financial media. Some of the UK’s leveraged pension schemes were forced into involuntary sales to raise collateral to maintain LDI positions. “The three largest players in the LDI market — BlackRock, LGIM and Insight Investment – have all issued collateral calls to UK pension clients so far this year.”8 Even Mercer intervenes:
High profile investment consultant Mercer sent a warning to pension scheme clients to prepare for additional margin calls. The portfolios were reportedly being subjected to “unprecedented liquidity strains” after cumulative interest rate increases of only 1.5%, highlighting the fragility of the system as the Bank of England ramped up its interest rate hiking cycle.9
On 21 July 2022, Toby Nangle writes in the FT:
LDI managers claim that their activities pose no systemic risk, and I read the Bank of England financial policy committee’s silence as agreement. But UK pension funds are collectively very large derivative counterparties and they move together. Scheme collateral buffers have been markedly depleted across the board and require rebuilding; this can only realistically happen by selling growth assets like corporate debt, equities and property. So, while rising yields are good news for pension scheme funding levels, they look a likely catalyst for a further liquidation of risky assets.10
And that is exactly what happened: the Bank of England remained silent and completely failed to see the build-up of systemic risk. The Bank of England, that venerable institution at the heart of the UK's financial system, wears two hats. On one side, it is the maestro of monetary policy, setting interest rates like a conductor leading an orchestra. On the other, it is the watchful guardian of financial stability, meant to spot trouble before it starts. However, in the run-up to the 2022 crisis, the Bank was less a vigilant guardian and more a distracted security guard, too busy polishing its inflation-targeting models to notice.
Leveraged LDI strategies expose pension funds to liquidity risks, especially during periods of market volatility. When interest rates rise sharply, the value of leveraged LDI positions can fall, triggering margin calls that require pension funds to post additional collateral or sell assets to meet these demands. Since most of these positions were unfunded, and with increased exposure to illiquid infrastructure and private equity assets, the increased requirements for collateral by the brokers on the other side of these derivative positions meant that the pension funds could only sell off their only remaining liquid assets: gilts. That created a self-reinforcing feedback loop, whereby increased selling of gilts led to higher interest rates and higher margin requirements for interest-sensitive derivatives contracts and back to increased pressure to sell more gilts.11
On 23 September 2022, Chancellor Kwasi Kwarteng announces a "mini-budget" with £45 billion in unfunded tax cuts, leading to a sharp rise in gilt yields and a fall in gilt prices. This triggered a major panic and selloff of gilts by pension funds already trying to unwind leveraged LDI strategies. Long-term interest rates spiked as they were forced to sell assets to meet collateral calls. The sharp rise in gilt yields in September 2022 led to significant mark-to-market losses for pension funds using leveraged LDI strategies. This forced them to sell assets, primarily gilts, at significant losses to meet liquidity calls, contributing to further market instability.12
Fixing the roof in the middle of a storm
Enter the Bank of England, with its uncanny ability to rationalise inaction. As gilt yields soared, the Bank of England possessed the power to set long-term interest rates by buying gilts at target maturities in any quantities needed. Instead of using this power to stabilise the market, the Bank chose inaction. Why? This decision appears to have been politically motivated. By letting the market dictate interest rates, the Bank acted contrary to the interests of the Truss Government. The UK's budget deficit was £229 billion just two years earlier, yet coordination between the Treasury and the Bank then kept long-term gilt rates under control. This time? The decision had more to do with playing power politics and teaching politicians a lesson about who is in charge.
As pension funds began panic-selling gilts to meet margin calls on their LDI positions, the Bank of England stood by and watched. It was akin to seeing a five-alarm fire and deciding it was a good time to repaint the fire truck. Only when the gilt market was on the brink of total meltdown did the Bank finally step in with emergency purchases.13 By then, the damage was done. Truss's government was already on the verge of collapse, eventually leading to her resignation from the shortest-lived premiership in UK history.
Political fallout and wrong lessons learned
In the aftermath, instead of facing scrutiny for its failure to regulate LDI and its delayed response to the crisis, the Bank managed to pull off a cover-up. Truss took the fall, and the Office for Budget Responsibility (OBR) – another institution that failed to foresee the LDI crisis – paradoxically gained more power. This was not just a story about financial mismanagement. It was a cautionary tale about the limits of central bank independence and its implications for democratic institutions. When an unelected body like the Bank of England can effectively topple a government through action – or inaction – we are in dangerous territory.
In a twist of irony, the very regulations meant to make pensions safer had made the whole financial system more fragile. The Bank of England, the guardian of financial stability, ended up playing a starring role in a political drama that toppled a government. Yet, policymakers drew the wrong conclusions. The Industry and Regulators Committee recommended improving stress tests and reviewing accounting standards, criticised the use of leveraged LDI strategies and called for better regulatory oversight, but it stopped short of blaming regulators for allowing leverage to build up in the private pension sector.14 Banks using similar strategies to leverage with financial derivatives are heavily regulated by the Bank of England, and there were many calls on the Bank of England’s Financial Policy Committee to recognise the systemic risks caused by the pension schemes’ use of complex derivatives to increase leverage.
Let us grant the Bank of England this charity: its inaction was not malice, but the myopia of a clockmaker who forgot why clocks exist. When the gears jam, do we curse the machinery or the craftsman who oiled loyalty into dogma? The real scandal is not that the Bank stood idle as gilt markets burned. It is that we have enshrined “central bank independence” as holy writ, neutering democracy’s power to price its own debt while outsourcing sovereignty to technocrats clutching inflation models like medieval relics. The Victorians at least had the decency to call their austerity “divine will.” We dress ours in the robes of decorated PhDs, the modern-day priests of neoclassical dogma who stormed Keynesian temples with gold-standard era texts in one hand and austerity hymnals in the other. The Blairites gifted us the Bank’s independence in 1997 – another Labour Government strangling its own legacy with the rope of neoliberal orthodoxy. Now Starmer’s cadre, heirs to this ritual of self-devouring, mistake the snake’s own tail for a prey and wonder why the working class feels bitten.
In July of 2024, Labour returned to power and began crafting legislation echoing the misguided spirit of the 2004 pension reforms. The goal was to reduce government responsibility for providing a state pension at similar levels to other European countries and to create more "certainty" around private pensions, ignoring the lessons of the LDI debacle. The proposals are just as ludicrous as the legislation that caused the LDI debacle: continue to subsidise pension savings at a significant cost to existing taxpayers, funnel these subsidised private pension savings to the extractive financial sector, and encourage the private sector to invest in infrastructure projects with a government guarantee for minimum returns and insurance against catastrophic loss.
Meanwhile, the OBR, rather than being scrutinised for its failures, was given more power.15 Liz Truss's attempt to sideline the OBR backfired spectacularly, elevating it to a mythical status as the guardian of fiscal prudence. The result? A new set of arbitrary constraints on government spending, enshrined in law and blessed by the OBR. It was as if, having narrowly avoided driving off a cliff, the UK decided the solution was to put a bigger engine in the car and drive even faster. By making a low national debt its primary goal, Labour continues in the same tradition of making the grave mistake of providing handouts to the private sector for the provision of basic services at a higher cost, despite these services being underwritten and guaranteed by the taxpayers in the long run; the only difference is that these “contingent” liabilities do not appear anywhere on the national debt, and Labour can claim fiscal prudence. Whether it is paying privatised local monopolies exorbitant fees for managing infrastructure or paying the financial sector management and commission fees, the ultimate result is the same: public services have been sold off to the rentier classes.
In the end, the UK's 2022 financial crisis was not just a failure of regulation or policy; it was a failure of imagination. Nobody – the Bank, the Government, nor financial experts – could imagine that the systems designed to make pensions safer could bring the entire financial system to its knees. It is a very British response to a crisis – polite, technocratic, and utterly, catastrophically misguided. And unless the right lessons are learned this time, it is a disaster bound to repeat itself.
Relate Publications
Emma Dawnay
References
[1] 2004 Pensions Schemes Act: This act attempts to minimise claims against the Pension Protection Fund (PPF), but like the previous risk transfers like with mortgage-backed securities that led to the 2008 global financial crisis, this step only transferred risk from the PPF to the financial system itself, as the size of LDI assets were poised to grow over the next 2 decades to become a significant systemic risk. https://www.legislation.gov.uk/ukpga/2004/35/contents
[2] FRS17 accounting standards: Required that pension scheme liabilities be placed onto corporate balance sheets, leading to an acceleration of the shift of defined benefit (DB) assets into fixed income from equities as sponsors worked to minimise any impact on their accounts from the volatility of equity investments. Bonds were relatively more stable and interest income was better matched to cash outflows of future pension liabilities. https://www.gov.uk/hmrc-internal-manuals/international-manual/intm523220
[3] Section 222 of the Pensions Act of 2004 mandates that defined benefit schemes maintain adequate assets to cover liabilities, and schemes falling short must submit a recovery plan to the UK's Pensions Regulator. https://www.legislation.gov.uk/ukpga/2004/35/section/222?view=plain
[4] Institutions of Occupational Retirement Provision (IORP) Directive: This EU law further reinforced the FRS17 accounting standards by requiring pension schemes to be fully funded at all times, subject to a limited recovery period. This law also allowed the use of derivatives for reducing investment risk in managing pension portfolios. Effectively, despite being prohibited from borrowing of money to increase leverage, pension funds were granted access to use derivatives to synthetically increase leverage. https://publications.parliament.uk/pa/cm5803/cmselect/cmworpen/826/report.html
[5] LDI strategies as a solution to balance sheet constraints introduced by the 2004 Pensions Schemes Act: https://www.plsa.co.uk/portals/0/Documents/0190_%20Accounting_for_PensionsL.pdf
[6] The UK Investment Management Association’s annual survey highlights the growth of LDI mandates to 38% of third-party pension mandates, driven by the need for defined benefit pension schemes to manage their future liabilities within the regulatory constraints in the UK’s defined benefit funding regime. https://www.theia.org/sites/default/files/2021-11/IA%20-%20Investment%20Management%20Survey%202020-2021.pdf
[7] Originally published on 21 March 2022 at https://www.hymans.co.uk/insights/blogs/blog/a-funding-boost-but-a-collateral-headache; content can be found on Internet Archive at https://web.archive.org/web/20221011142309/https://www.hymans.co.uk/insights/blogs/blog/a-funding-boost-but-a-collateral-headache
[8] https://www.ft.com/content/09cc7f6a-8da8-43f5-bf30-d3216d0eb28d
[9] Ibid.
[10] https://www.ft.com/content/83927688-e0d1-4934-8d91-e279da6d6b6c
[11] https://www.chicagofed.org/publications/chicago-fed-letter/2023/480
[13] The Bank of England intervenes by purchasing gilts to stabilise the market and prevent a downward spiral in government debt markets. This action is essential in restoring financial stability and preventing further losses for pension funds. https://www.imf.org/en/Publications/WP/Issues/2023/09/29/Putting-Out-the-NBFIRE-Lessons-from-the-UK-s-Liability-Driven-Investment-LDI-Crisis-539683
