Rich on paper, short of cash: the pension paradox

Britain's defined-benefit pension industry spent the past week learning the difference between being solvent and having cash. On paper, the jump in long-dated gilt yields over the past year has been excellent news for pension funds. Their liabilities are discounted at long-term government bond rates, so higher yields shrink the present value of what they owe, and fast. By the usual actuarial measures, UK schemes went into the autumn of 2022 better funded than at any time in a generation. On Wednesday, 28 September, many of them were hours from being unable to pay their bills.

Hence the pension paradox, rich on paper and short of cash. Schemes with funding ratios above 100 per cent were suddenly dumping high-grade assets at fire-sale prices to meet margin calls on their interest-rate derivatives. The crisis showed that an institution can have a spotless balance sheet and still be unable to settle an intraday cash call from its clearing broker.

Safety rules built the trap

The structure grew out of rules meant to make pensions safer. The Pensions Act 2004 created the Pension Protection Fund and a regulator able to demand that deficits be repaired, and accounting standards adopted in the early 2000s put pension deficits on company balance sheets, where every fall in gilt yields dented reported earnings. Sponsors wanted the swings gone. Leveraged hedging promised to remove them while leaving room for growth assets, and trustees across the industry took up the offer.

Locked into illiquid assets

The weakness was built over the past decade, as pension trustees moved money in large amounts. Fed up with near-zero gilt yields, schemes shifted capital into private markets, including private debt and unlisted infrastructure as well as timberland and private equity funds. These holdings paid a premium for illiquidity that flattered actuarial returns, and they smoothed reported volatility because their valuations were updated late.

Liabilities shrank and private assets kept their stale valuations. The derivatives used to hedge interest-rate risk, however, required variation margin in cash or something close to it. When the gilt market broke, the illiquid assets became dead weight. A stake in a private equity fund or an offshore wind farm cannot be handed to a clearing house at three in the afternoon to cover a margin shortfall. Only sterling cash, short-dated Treasury bills or unencumbered gilts will do.

Size decided how fast a scheme could respond. Large schemes with segregated mandates could post collateral directly. Smaller ones invested through pooled LDI funds, which had to call cash from many trustees at once, and a scheme that could not pay within days risked having its hedge cut, leaving it exposed to exactly the move in yields it had paid to guard against.

Selling what could be sold

With their private holdings in effect frozen, pension managers sold their other liquid assets. Corporate bonds and senior asset-backed securities went out at steep discounts, and so did blue-chip shares. When that still did not raise enough cash, trustees had to sell the very gilts their liability models were built around. The forced selling pushed yields higher, widened the margin shortfall and drained what liquidity the sector had left.

Every sale of a liquid asset also made the rest of the portfolio less liquid. With bonds and shares sold and the private holdings untouched, the illiquid share of each scheme's assets rose, in some cases beyond the limits in its own investment policy. Trustees who wanted to rebalance faced the same problem that had caused the crisis: the assets they held too much of were the ones nobody could buy in a hurry.

The Bank of England's promise to buy up to £5 billion of long-dated gilts a day provided an artificial bid that stopped the fire sale. In its first operations the Bank bought far less than that limit, a sign that the presence of a willing buyer mattered more than the volume it bought. It bought time and did nothing about the mismatch on pension scheme balance sheets. The support is temporary by design: the Bank has said it will buy only until 14 October, with a Treasury indemnity, and has pushed back its own planned gilt sales to the end of October. Trustees are now pressing corporate sponsors for fresh money or negotiating emergency credit lines with banks, trying to rebuild their cash buffers before the central bank's support ends.

Endowments learned this in 2008

The closest precedent comes from America's university endowments. Harvard and other large endowments had built up private equity and hedge-fund portfolios through the 2000s, and when markets broke in late 2008 they found themselves with capital calls to meet and little cash to meet them. Some borrowed in the bond market and others sold private equity stakes on the secondary market at deep discounts. Their long-term returns recovered, but the fire sales were permanent losses, and many endowments spent the following years rebuilding cash reserves they had once considered wasteful.

Who gains from the fire sale

Every forced seller has a buyer. Secondary funds that buy private equity stakes second-hand, and credit investors with spare cash, are being offered assets by sellers who cannot wait. Insurers gain too, because higher gilt yields make it cheaper for sponsors to transfer schemes in bulk annuity buy-outs, where many well-funded schemes were heading anyway. The case against the gloom is that the funding gains are real and survive the crisis, so a scheme that rebuilds its collateral could end the year closer to buy-out than it started; that settles the solvency question and leaves the liquidity one open until the leverage comes down.

The weeks ahead set the test. Schemes must rebuild buffers before 14 October, when the Bank's bid disappears, and before the government's medium-term fiscal plan on 23 November, which will decide whether long yields settle or jump again. Any guidance from the Pensions Regulator on minimum collateral buffers will show how much leverage the industry is allowed to keep.

The cost will fall on corporate Britain. Companies that thought their pension problems were finally behind them will see cash diverted from dividends and investment into emergency collateral pools. A healthy funding ratio is a comfort in normal times, and in a crisis only cash settles the margin call. Trustees will spend the coming months selling illiquid assets or asking sponsors for cash, and schemes that paired private assets with leveraged hedges will have to choose between the two before the Bank's support runs out in mid-October.