Five ways the gilts crisis could affect your pension

Alice Guy examines how this week’s gilts crisis could affect your pension.

When two strong forces pull in the opposite direction, chaos will often follow. In this case, conflicting actions by the Bank of England (BoE) and British government last week contributed to the falling pound and the current gilts crisis.

The central bank raised interest rates to try and lower inflation, swiftly followed the next day by the government announcing inflation-stimulating tax cuts. The market reaction was brutal and the pound plummeted, followed by plunging gilt prices on Wednesday.

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In response, the Bank of England, much criticised for being too soft on interest rates, stepped in to prop up the faltering gilts market. In a compete U-turn, the central bank announced a plan to buy back £65 billion of long-dated government bonds, introducing yet more quantitative easing into the system just weeks before it was due to start just the opposite – quantitative tightening.

Gilts crisis

Jim Reid, strategist at Deutsche Bank, explains: “In yield terms, 30-year gilts had been trading above 5% prior to the BoE’s announcement, but afterwards they staged a stunning turnaround to fall by an astonishing 105.9 basis points (bps) yesterday. That was easily the largest decline in the 30 years of available Bloomberg data, with the next two closest being a -39.7bps and -30.5bps decline in 1997 and 2009, respectively.”

The gilts crisis is just part of the market reaction to the mini-budget last Friday, as the markets gave a resounding thumbs down to the government’s apparent lack of fiscal control.

Ajay Rajadhyaksha of Barclays commented: “Bond and currency markets have reacted so poorly since the mini-budget, at least in part due to fears that the move added new fiscal stimulus to an economy that already had 10% inflation and a very low jobless rate. It’s difficult to see how this perception can be corrected by new monetary policy stimulus."

Stock market volatility continued today, with the FTSE 100 giving up yesterday’s gains, falling back below 7,000 and reaching 6,842 in afternoon trade.

1. Defined benefit pensions

Defined benefit pensions rely on government bonds, or gilts to fund their pension liabilities, needing to invest in something relatively safe to cover their short-term obligations.

The sudden slump in the gilts market left many pension funds with a big problem – they were forced to sell more gilts than planned to meet their funding requirements, sending prices spiralling.

Becky O'Connor, Head of Pensions and Savings, interactive investor, explains: “The move from the Bank of England was in part to support defined benefit pension schemes that have been under significant pressure to generate cash quickly, risking a vicious cycle where they would have had to sell more gilts, pushing up yields further.”

The plummeting gilts market initially caused severe funding problems for some defined benefit pension schemes. But yesterday’s move by the Bank of England has gone a long way to calming the waters, supporting gilt prices and making it easier for defined benefit pensions to meet their obligations.

2. Annuities

Insurance companies rely on gilt yields to fund their pension annuities, and recent falling gilt prices have pushed up annuity rates to their highest level for years. That’s because there is an inverse relationship between gilt price and yield whereby lower prices means a higher yield.

A 65-year-old with pension pot of £100,000 could currently buy a single life annuity yearly income of £6,637, compared to £4,941 just one year ago, adding up to an extra £34,000 over 20 years. 

Rising annuity levels could be good news if you want to buy a stable and predictable pension income, rather than keeping your pension pot invested and opting for income drawdown. However, rising inflation is likely to erode the value of annuity incomes in real terms, more of which later.

3. Inflation and pension income

Students of economics will know that quantitative easing, or QE has a long-term inflationary effect as it adds more money into the system. In turn, rising inflation will have a long-term negative impact on your pension income, whether taken through an annuity or income drawdown.

Pensioners who are using income drawdown to fund retirement will need to withdraw more from their pension pot to achieve the same level of purchasing power. There’s a risk that they will deplete their capital wealth at a higher rate than planned and end up running out of money, or with a lower pension income in the future.

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Meanwhile, pensioners with a level or even escalating annuity could find themselves short of money if their income doesn’t match their cash needs. An annuity income that seemed generous at 65-years-old could be worth a lot less if someone lived to 80 or 90 years old.

4. Stock market

It’s too early to tell how this crisis will play out. Only time will tell if the government is prepared to pull back from it’s fiscal-expansionary tax cuts.

Bethany Payne, Global Bonds Portfolio Manager at Janus Henderson, commented: “Today’s announcement will stem some of the tide of selling flows we were expecting this week, but is only a sticking plaster to a much wider problem. The IMF warned the UK government overnight to ‘re-evaluate’ tax cuts, but did the Bank of England just give them the green light to continue with their plans? Certainly, the market would have benefitted more from the government blinking first, not the other way around.”

In the meantime the uncertainty surrounding interest rates, inflation and ongoing government policy is fuelling stock market volatility. Unless something drastic changes, that volatility is likely to continue for the foreseeable future.

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Those still a way off retirement should have time to recoup any short-term losses, and a falling stock market can even be an opportunity to pick up some bargains. But those nearing retirement may need to consider some strategies to protect themselves from potential short-term losses.

5. Recession risk

Unless a U-turn is around the corner, government fiscal loosening and quantitative easing in response to the gilts crisis is likely to fuel further inflation. If inflation increases, there is a big chance of a 0.75% or even 1% base rate rise at the next Bank of England meeting in November.

Rising interest rates will have a dampening effect on the economy, making it more expensive for businesses and consumers to borrow. The higher that rates need to climb, the greater the risk of a long and deep recession.

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For long-term investors with time on their side, it’s important to sit tight, resist the urge to sell low, and wait for the economic storm to blow over.