Are we doubling down on systemic risk in pensions?

Stand by for the big deadline. After a week of emergency moves and mangled communication, the Bank of England underlined its intention to stop emergency purchases of gilts as scheduled on Friday.

Defined benefit pensions funds are still scrambling to sell assets to meet collateral calls on so-called liability-driven investments (LDI). The gilts market is fragile, with fears of more market volatility once the Bank’s safety net is withdrawn.

There is also a lower-profile deadline approaching next week. It falls squarely into the wonky world of pensions policy that, until recently, would largely have been ignored (or dismissed as desperately boring). But it is causing consternation and has direct links to the current crisis.

The government is putting together a new legal framework for defined benefit pension schemes, laying out the rules for their funding and investment strategies as these old-style pensions wind towards their end. A consultation, launched by the Department for Work and Pensions in July, ends on Monday. The Pensions Regulator will do its own work on a code of practice for how schemes can comply with new requirements later in the year.

So far, so fascinating. But the thrust of the government’s proposals should sound familiar. It wants stricter, legally-binding requirements for pension schemes to improve funding as members hit retirement, and to adopt a “low dependency” strategy that cuts investment risk. That means a reduced likelihood of calling on the company sponsor for additional support. Such a strategy involves matching cash flows from investments to pay liabilities, usually by buying government bonds, and insulating schemes from short-term changes in market conditions. In other words, LDI.

This has been the direction of travel for some 25 years. Not everyone likes it, including the government — confusingly — which at times seems keen to suggest that more pension money should be directed at UK infrastructure and UK growth. 

Leaving that aside, the push to “de-risk” pensions is what prompted LDI investing in its basic form. Then, the use of leverage in LDI vehicles was in part an attempt to amp up gilt exposure in a capital efficient way, while leaving capacity for higher-return investments that could help a fund earn its way back to health.

It is an odd time for the biggest sector shake up in about 20 years. Higher interest rates can mean vastly improved pension scheme funding. But they can also shorten the time before a scheme is considered “significantly mature” under the proposals, (or roughly when most of its members are retired). That’s the point at which the government wants a scheme to be “low dependency”. Recent market moves would mean that the time before that obligation would kick in has dropped from a decade to just a couple of years for some schemes, says Jonathan Camfield, partner at consultant LCP.

A more rigid set of requirements proposed for all schemes has also prompted concerns about the £1.5tn sector pushing harder in the same direction at the same time. The DWP has said it intends to retain “the strengths of a flexible, scheme-specific approach”. But Camfield worries that “the new rules would require reasonably material, faster de-risking across the board”.

Not only might weaker schemes struggle, requiring additional funding from corporate backers, but — without strong oversight — this could create its own problems: “If you shoehorn everyone into one destination, you increase concentration risk which in extremis becomes systemic risk,” says Patrick Bloomfield at consultant Hymans Robertson.

Not everyone agrees. John Ralfe, the founding father of pension scheme de-risking, dismisses worries about lack of flexibility as “special pleading” from an industry that thrives on complexity. In his view: “events of the last two or three weeks are a very strong argument in favour of prescription and tougher rules.”

They are certainly an argument in favour of paying much closer attention, as the Bank of England effectively acknowledged in its stability report last Thursday. Despite a phalanx of regulators supposedly overseeing different elements of the pension universe, a pocket of poorly understood leverage created a system-wide risk that — despite being specifically looked at by watchdogs — wasn’t properly appreciated or monitored. 

This week’s deadline will determine the next phase in this crisis. Next week’s demonstrates that the issues involved are not going away.

helen.thomas@ft.com
@helentbiz