Written evidence from Richard Britton LDI0074

(Previously submitted LDI0005)

Defined Benefit pensions with liability driven investments – extended Call for Evidence.

Date: 1 March 2023

This second written evidence is submitted by Richard Britton in a personal capacity. I make this submission in response to the Committee’s request for further views and comments.

One aspect of the LDI debacle that I have not seen discussed is the long term role of the Treasury, its  continued reliance for the last decade on index linked gilts to fund a substantial part of the UK borrowing requirement, the part that played in the events of last September and what lessons should be learned.  

I would therefore like to suggest that the Committee asks Ministers why, in the ultra-low inflationary environment of the last decade, the Treasury, through the DMO, continued to issue large amounts of index linked gilts and did not take full advantage of the record low real yields on long term conventionals. According to the DMO’s table of monthly conventional long dated gilt yields, these dropped, below 3% in October 2014, stayed low, bottomed at 0.6% in May 2020 and did not exceed 2% until May 2022.  In so doing the Treasury appears to have decided to forgo the opportunity to maximise long term borrowing at historically low interest rates and instead exposed the public finances to 30 years or more of unpredictable but potentially very large increases in inflation linked coupon payments and final principal amounts at maturity.                                                   

What was the rationale underlying what seems a high risk policy?  I can see three possibilities.

1. There was a conscious policy to buttress perceived weaknesses in the finances of DB pension schemes, many of which closed to new members in that period, and to protect the PPF;
2. There was a conscious effort to reduce the growing risk, as Mark Carney put it in his 2017 speech at the Mansion House, of the UK’s reliance on the “kindness of strangers”;
3. There was an unconscious, or poorly thought through, commonality of interests between the Treasury/DMO and the DB pension schemes whereby the Treasury knew it could, with no effort, raise as much money as it wanted from this captive group of domestic investors, and the schemes’ trustees could relax, believing they had protected their liabilities from inflation. 

Commentators seem largely to accept that there was a good case in 1981 for issuing index-linked gilts as conventional gilt rates above 10% were still negative and there was what has been described as a “buyers’ strike”.   It is perhaps not a coincidence that issues were initially limited to pension funds and institutions writing pension business.  Excessive concentration in DB pension schemes was baked in from the start and allowed to continue to the present day.

Throughout the last decade fund managers expected that the Treasury would continue to issue index linked gilts on a large scale and DB funds would buy every issue. This is clearly set out in a marketing document from a leading LDI manager in 2016 which says that “UK private sector defined benefit schemes already own an estimated 80% of the long-dated index-linked gilt market and potential demand is almost five times the size of the market”.  It also says that “supply is expected to remain high and is likely to increase the market by around a third over the next five years, (my underline) but this will not come close to matching demand”.  It also adds that “other sources of inflation protection exist but can only bring partial relief”. 

Extreme concentration of ownership of long dated index-linked gilts in DB pension funds was identified at least as long ago as 2016, as this document makes clear, but not, it seems, the potential danger inherent in the absence of alternative buyers should DB funds collectively come under pressure to sell.

In economic terms, no one in authority was paying attention to the growing systemic risk.    Why was this?

I thought that Baroness Bowles summed up the issue well in the House of Lords Grand Committee debate on the Financial Services and Markets Bill on February 20th. I set out extracts from Hansard here.

It is true that, in 2018, the Financial Policy Committee noted the fact that leverage in pension funds was greater than in hedge funds. It also noted the substantial concentration - indeed, almost a cornering of the market - in index-linked gilts. ………  Frankly, nothing got changed. Nothing was done on leverage. The Bank sat happily by as sponsor companies effectively ran off-balance sheet hedge funds in their pension schemes. Nothing was done about the concentration in index-linked gilts and - guess what? - when the glitch came, due to the mini-Budget, the part of the market that was cornered found it had nobody else to sell to. So, it was a pretty bad job all round.

Meanwhile, many are patting themselves on the back because the mark-to-market valuations, following accounting standards based on gilt discount rates, make it look as if liabilities have dropped more than the drop in asset valuations, so they say that the losses do not matter. It is, of course, an illusion: the pensioners are paid out of real assets and the losses will be paid for, down the line, by the sponsor companies and the taxpayer via tax relief. That will be measured in very many billions.

My one reservation about the noble Baroness’s analysis is that by 2018, it may have been too late to put in place effective risk mitigation mechanisms. Hence my question as to why the Treasury/DMO chose, from at least 2014, to continue to add fuel to the fire.      

March 2023