The UK pension fund crisis shows that there is no capitalism without capital and risk
The writer is co-founder of Ondra Partners
It is beyond ironic that an investment strategy that claimed to eliminate risk this week threatened the unprecedented failure of Britain’s pension system.
Much of the focus so far has been on what happened in the few days leading up to the Bank of England’s emergency intervention on Wednesday to stem a pension fund crisis on the so-called responsibility-oriented investment strategies.
These strategies aim to hedge the funds’ liabilities to meet their retirement promises through the use of derivatives. But they suddenly exposed the sector to a now infamous ‘catastrophic loop’, when falling gilt prices sparked calls for schemes to provide more collateral on such deals, in turn spurring more bond sales. British statesmen to raise funds.
However, the origins of the crisis go back more than 25 years when some members of the current government were still in high school. Beginning in the late 1990s, a series of tax and regulatory changes made it so onerous for companies to provide defined benefit pension plans to their employees that, by and large, companies closed their funds to new members.
These plans typically promised workers a retirement income equal to a multiple of their years of service. Closing the vast majority of these schemes to new members would have seismic – and entirely foreseeable – implications for the UK economy and financial system over the next two decades. It led to a profound change in the way funds would be managed due to the combined interaction of two factors.
First, the funds now had a finite time horizon, serving only existing members, and were therefore no longer indefinite intergenerational savings vehicles. On the contrary, they were more akin to annuities and should be managed as such. For example, their now shortened time horizons have made it harder to recover from the impact of bad investments, which has significantly reduced their risk appetite.
Second, the corporate sponsors’ risk profiles were asymmetrical – the corporations were responsible for all fund shortfalls and losses, but had no convenient access to any upward surpluses until the last retiree died. They have therefore behaved quite rationally to support pension plan trustees in their quest to eliminate all risk.
These two factors, combined with increasing longevity, have since had devastating consequences for the entire UK economy. The recent collapse is just an inevitable culmination of those earlier decisions.
The pursuit of zero risk has led to a massive and permanent shift in the asset allocation of pension funds – the proportion of their funds invested in bonds has risen from less than 20% in 2000 to 72% in 2021. Investments in listed UK stocks have steadily declined from 50% of their asset allocation in 2000 to 4% in 2021.
For all intents and purposes, defined benefit pension funds have stopped providing long-term equity to invest in the growth of UK businesses. The pool of equity built up by these funds over generations has largely been depleted.
This has reduced funding for local research and innovation centers while making critical infrastructure and much of the country’s technology and defense sectors dependent on foreign companies or private equity for capital.
Tragically, we have been left with an emasculated system that is unwittingly self-destructive and, as this week has shown, still remains vulnerable. If anything good is to come out of this latest crisis, it is hopefully a recognition that, rather than a few tweaks here and there, we now need to change this system from the ground up, once and for all.
The UK government should urgently commission a formal inquiry into how the country’s pension savings system may have been exposed to such extreme risk and what steps can be taken to ensure it can never happen again.
We now need to build a new, longer-term and more resilient savings system better suited to the long-term interests and global competitiveness of the real economy. We need a pension system that is more inclusive for all generations and above all capable of providing long-term risk capital to support the economic growth ambitions to which our new government is committed.
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