U.K. Pension funds mainly invest in bonds

The Chancellor wants U.K. Pension funds to invest more in U.K. companies and infrastructure. Pension funds would need to be persuaded such investments would make them better returns at acceptable levels of risk.

She needs to study just how U.K. pension funds came to be dominated by bond investment, and to review the LDI pension fund bond collapse of autumn 2022. Regulators and the advisory industry directed Trustees of funds to more U.K. bonds based on the doctrine that U.K. government bonds were assets that matched their liabilities. They also regarded them as low risk, as no one thinks a future U.K. government will fail to pay the interest or fail to repay the capital on the maturity date.

You can argue that far from being a matched asset a conventional long government bond means a fund does not match the inflation in liabilities all the time the member of the fund is still working. The pension liability for such a member will be rising in line with their wages. On retirement the pensioner would like pension increases to keep in line with prices. Often Trustees can only afford lower or no increases. Conventional gilts can only match a defined need for cash that does not increase with inflation.

You can go onto argue that an investment in a spread of properties or shares can match liabilities better. Over the longer term these assets will provide increasing rent or dividends that should keep pace with inflation. This will be reflected in rising asset values. You could however experience sharp falls in bear markets and need to keep sufficient cash or safer assets to pay a couple of years bills without needing to sell depressed real assets.

In 2022 many pension funds owned more bond than they could afford to pay for to give them greater future cash flows to match estimated liabilities. When The Bank changed policy from cutting interest rates and buying bonds to the opposite the bond market fell sharply. As prices of bonds fell so pension funds had to put up more cash to the geared bond funds they had bought into to protect the funds from the growing losses, as the bonds were bought on margin. The pension funds often had to sell bonds they owned outright to pay the extra bills on the bond funds which needed money to pay their debts.A fund might buy six times the amount of Bond it could afford, only paying say 10% of the full price. When the price fell it had to pay more.

The Regulators should ask themselves how this all happened. It should have reminded them that far from being safe you can lose very large sums if you own long dated bonds when interest rates go up and bond prices fall.