Is my pension at risk?

The headlines are bleak and investors are right to ask questions about pension security. We explain whether or not they should be worried about the current pensions crisis.

Bond markets have been ignored by many retail investors and the mainstream press for years, ever since the financial crisis caused a plunge in bond yields. But the yield on UK government bonds, also known as gilts, has surged in recent months as interest rates have been increased sharply to tackle inflation. Recent political decisions have also caused financial markets to lose confidence in the UK economy.

Private defined benefit pension schemes could be affected by the current gilts crisis, but the good news is that there are lots of protections in place.

Here we explain which pensions could be affected by the current crisis and why.

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Different types of pension scheme

Let’s get back to basics and look under the bonnet of our pension schemes.

There are two different types of pension scheme: defined benefit and defined contribution.

Defined contribution pensions are where you save up a pot by investing in shares, funds or other types of investment. They are either workplace or private pensions: you can invest using a self-invested personal pension, or SIPP, or other type of private pension.

Defined contribution pensions aren’t directly affected by the current crisis, but there could be an indirect impact for investors. I'll talk about this more later.  

Defined benefit pensions are workplace pensions that guarantee a proportion of your average, or final salary when you retire. They were often referred to in the past as final salary pensions.  

Defined benefit pensions are split into two types: public sector pensions and private defined benefit pensions. 

Public sector pensions are funded directly by the taxpayer and therefore won’t be affected by the current crisis.

Private defined benefit pensions may be affected by the crisis as the schemes invest in gilts to pay for the pensions of its members. And it is plunging gilt prices that have sparked the current crisis.

Defined benefit pensions and gilts explained

Private defined benefit pension schemes must follow complex rules and make sure they have enough assets to cover their liabilities.

One way that schemes cover liabilities is by investing in gilts through complicated financial instruments called Liability Driven Investments (LDIs).

Gilts are a type of government debt where investors receive a set amount of interest each year and a guaranteed amount of their investment back if they hold the gilt to maturity. Gilt prices have fallen in recent months as interest rates have risen, which means the value of gilt portfolios has also declined.

Pension funds buy LDI products from asset managers like BlackRock and Legal & General to help them meet their future commitments. Pension schemes borrow money to buy gilts, then repay the loan when a gilt matures. In the meantime, they need to hold some gilts as collateral under the terms of their contract: a bit like mortgage lenders requiring a charge on your house.

Pension schemes also invest in what are known as interest rate swaps through LDIs - this a contract where two parties agree to swap future interest rate payments received on different products. If interest rates rise, they need to provide more collateral.

Current pension crisis

At the end of September, in reaction to the UK government’s mini-budget, gilt prices fell sharply and pension schemes saw the value of their collateral fall. LDI managers came asking for more cash so that schemes could meet their collateral commitments. In the industry, this is a called cash margin call.

Pension funds were forced to sell their gilts for knock-down prices and, as they did so, gilt prices dropped even further, worsening the situation. The Bank of England (BoE) stepped in to end the doom cycle and stabilise the gilts market.

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For a while, it looked like some pension funds might run out of cash to top up their collateral. This would have led to some schemes defaulting and could have spilled over into other areas of the financial markets – but would probably not have directly affected the scheme members’ pensions.

According to one report, only 3.6% of schemes had failed to meet the collateral calls made upon them and defaulted on some of their financial contracts. In total, 5.8% reported difficulties with their LDI funds. Another poll indicated that only 7% of schemes had seen their funding ratios decline. According to Henry Tapper, chair of AgeWage, "these schemes had...been over-hedging, that is speculating imprudently and recklessly on further declines in interest rates."

Pensions Regulator’s chief executive Charles Counsell explained that: “It is absolutely clear that there have been liquidity issues in some of the funds, but that does not mean that pension schemes themselves are at risk of collapse,

“We’ve had to deal with liquidity issues very quickly. Indeed, we’ve seen, if anything, longer-term funding positions of pension schemes improve as a result of the increase in gilt yields.”

So, most schemes are hopefully not affected, and the good news is that there's also a safety net. Employers are required to fund struggling schemes and the Pension Protection Fund means you’re protected if your employer is insolvent and can’t fund your pension. The fund usually pays 100% compensation if you’ve reached the scheme’s pension age, and 90% compensation if you’re below the scheme’s pension age.

What is the Bank of England doing?

As gilt prices plunged, the Bank of England promised to buy back its own gilts. This raised the price of gilts as markets were reassured the bank would buy gilts at auction over the next few weeks.

The intervention provided temporary relief, but not for long, as the gilt market continued to wobble at the beginning of October. The bank was forced to step in again with further reassurance of more gilt buy-backs. This intervention is due to end on Friday 14 October, and gilt prices have slumped to their lowest level again. Although serious, it was the sudden sell-off that caused the biggest problem as schemes scrambled to meet their commitments.

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Victoria Scholar, Head of Investment, interactive investor, said: “The Bank of England was forced to prop up the government bond market after the chancellor’s mini-budget sparked a sell-off for the pound and gilts, posing a major risk to some of the UK’s biggest pension funds amid rising collateral calls on LDIs. The central bank’s action has helped to calm government debt markets but there are concerns about what happens next week after the Bank of England’s support package ends with question marks around whether dysfunction will return to the market.”

What does the gilts crisis mean for the economy and investors?

Most investors aren’t directly affected by the gilts crisis. However, the pervading sense of chaos is having a dampening effect on UK financial markets, which continue to suffer this week.

The Bank of England’s intervention also adds more money into the system through quantitative easing, or QE, which has a long-term inflationary impact so makes medium-term inflation and higher interest rate rises more likely.

There’s also more mortgage pain on the horizon as markets expect interest rates to rise to 6% or more. The cost for mortgage holders will be higher as mortgage rates typical track around 2.5% higher than the BoE base rate.

For investors not directly affected, it’s a reminder of the importance of diversification and investing across many geographies as well as the UK.

The FTSE 100 is more affected by global markets than the UK as most profits are made abroad: it’s down 10% in the past month, whereas the UK-based FTSE 250 is down 15% over the same period.

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If you’re worried about your defined benefit pension and are thinking of transferring out, then it’s important to get independent financial advice. Obtaining independent advice is a legal requirement if your DB scheme is worth more than £30,000.

The Financial Conduct Authority and the Pensions Regulator have information available to help you understand more about your defined benefit pension and to think about what to consider. You can also get free, impartial guidance from the government website, MoneyHelper.