AJ Bell press comment – 12 October 2022
- Despite daily headlines about pensions being in turmoil, there is very little chance anyone’s retirement pot will be fatally damaged by the current crisis
- The issue the Bank of England is wrestling with specifically relates to hedging strategies employed by defined benefit (DB) pension funds, where the risk sits with the employer, not the individual
- Most people building up a retirement pot in a defined contribution (DC) scheme will experience minimal impact (although those with large holdings of UK Government bonds will have seen the value of their funds drop)
- The safety of DB pensions hinges entirely on the solvency of the sponsoring employer
- Even if the employer goes bust – which is extremely unlikely – the Pension Protection Fund (PPF) provides a valuable safety net
Tom Selby, head of retirement policy at AJ Bell, comments:
“Savers and retirees are understandably nervous about constant ‘pensions crisis’ headlines. However, it is very unlikely what is happening will mean your pension is at risk.
“These days, the vast majority of people build up ‘defined contribution’ (DC) pension. The crucial thing for people to understand is that these DC pensions are not what the front-page headlines are all about.
“Instead, the issue which has triggered intervention from the Bank of England centres around defined benefit pension (DB) pension funds. These are a completely different type of pension where it is the employer, not the individual, that shoulders the risk involved, and there are layers of protection in place to ensure pensions are paid.
“It is also worth adding that the state pension is entirely unaffected by all this. Likewise, the issue has no bearing on almost all public sector DB pensions, the majority of which are ‘unfunded’, meaning pension income is paid from taxes, not from an investment. Finally, if you already have a pension income paid from an annuity, this should continue to be paid with no changes.”
DC pensions
“A DC pension is invested in funds, shares and bonds, but should be diversified across a range of assets in different countries around the world, meaning any short-term uncertainty in the UK should have a very limited long-term impact on your retirement prospects. The value of the pension will rise and fall over time, and people with these pensions may be concerned about that volatility, but it is important to remember it is normal in any long-term investment.
“The one group of people in DC pensions who should perhaps be concerned at the moment by movements in bond markets are those in annuity hedging strategies, which use ‘lifestyling’ to move into bonds as a chosen retirement date is approaching. Those sat in these funds who no longer plan to buy an annuity are likely to be sitting on significant losses (see analysis here).
“Beyond that, there is no reason to be overly concerned over the current crisis, which is about government bond sell-offs and the risks posed by a specific type of hedging strategy operated by ‘defined benefit’ pension schemes.”
Liability Driven Investments and the bond sell-off
“Pensions have been dragged into this crisis by a popular hedging strategy used by DB schemes called Liability Driven Investing, or LDI. These aim to effectively cancel out the impact gilt yields has on the accounting value of liabilities.
“In simple terms, when gilt yields go up and the value of liabilities consequently goes down, the pension scheme is required to pay money to the investment bank running the hedge. If gilt yields went down and liabilities went up, the scheme would receive money from the hedge.
“Where yields move quickly – as in recent weeks – the hedges demand extra cash which, in turn, would force pension funds to sell-off more gilts, potentially creating a dangerous death spiral. This is what the Bank of England’s intervention was designed to prevent.
“However, none of this should materially impact on whether or not members of DB schemes are paid the pensions they are owed. Ructions in bond markets are no reason to believe there is a threat to the solvency of employer sponsors, which is the key issue for DB pension holders – provided the sponsoring employer stays in business, you should receive the pension you were promised.
“There are layers of protection in place here too. DB schemes are tightly regulated to ensure they remain solvent and that employer sponsors keep the pension scheme in a healthy position.
“Even in an extreme scenario where a DB scheme sponsor does go bust and can no longer support the pension scheme the Pension Protection Fund (PPF) provides a valuable safety net.”
