There have been some worrying things said in recent days about people’s pensions — from talk of “material risks” to “doom loops” and pension funds “blowing up”.
Unsurprisingly, millions of people who are saving into a pension have been left wondering what on earth is going on, and whether their retirement savings will disappear in a puff of smoke. So it’s worth getting to grips with what’s going on and how it affects us.
The problems started with the mini-budget, and all its unfunded tax cuts. It worried investors, who felt the UK might be a less financially sensible government to lend to than it previously thought, and they sold up in droves and took their money elsewhere. This caused the value of UK government bonds — or gilts — to plunge.
How this affects you personally depends partly on the type of pension you have.
Most of us are in a defined contribution scheme, where a specific sum is paid in, and invested, to build a pot, and then it’s up to you to work out how to take an income from it.
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If you have this kind of pension, and you haven’t made a specific decision about how this money is invested, it will be in what is known as the default fund.
If you have a long way to go to retirement, you’ll be in the “growth phase” of these funds, which hold some bonds, but lots of shares too.
They have fallen in the year to date, but that’s to be expected. On average the fall is around 12%. Over the long term they are still delivering for members — up around 15% on average over the last 5 years.
You should check the default fund meets your needs, but there’s no need to make any sudden moves. You should have plenty of time to ride out even these worrying short-term movements.
For those whose retirement is closer, whose money is in a defined contribution pension, the key issue will be how much of your money is in gilts. Old-style pension funds are set up to gradually move into more and more gilts as you get older, so you end up with 75% in gilts and 25% in cash at your retirement age.
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If you are close to retirement, and this move has taken place, you could have seen your fund fall on average by 38% in the year to date. This is clearly terrifying for someone approaching retirement.
The silver lining to this news is that if someone was due to buy an annuity, then while they may understandably be unnerved by a big fall in value, their income has held up reasonably well. As these “old style” funds have fallen, so annuity rates have improved.
Annuity rates have risen by 45% from the start of the year. Back then, when the rate was rate was 4.95%, £100,000 would have bought a 65-year-old a non-increasing annual income of £4,950. Today, when the rate is rate is 7.19%, it would be able to buy an income of around £7,190.
If you were planning to use drawdown to access the money, the good news is that you won’t need it all on day one, so you can leave the vast majority of it invested to grow over the decades of your retirement. However, you will need to revisit your investment strategy to find the right balance of assets for your needs.
It’s also worth looking at your position now, and considering what income you can sensibly take from your pension — if you can supplement it with other savings and investments, or whether you need to consider adding part time work to the mix for a while.
Read more: Pensions: Workplace schemes are a hit but cost of living crisis remains a threat
If you have a defined benefit scheme, you pay into it in return for a guaranteed income in retirement. These schemes have hit the headlines, because their funding strategies have gone awry.
This is more complicated, but the takeaway is much more reassuring. In defined benefit schemes it is the employer who is ultimately responsible for making up any shortfall in the funding of the scheme, not you — so don’t let this scare you into doing anything with your defined benefit pension.
The science bit
You may find it more reassuring to actually understand what has been going on behind the scenes. Defined benefit pension funds have faced difficulties partly because of something known as leveraged liability driven investing. This sounds complicated, but bear with me.
The liabilities of a scheme are the incomes they’ve promised to pay members, and when they’re valued, they’re tracked back to their cost today using interest rates.
The pension scheme has to make sure that the fund not only grows, but matches those liabilities too. Traditionally they used gilts to do this, but leveraged LDI uses financial instruments to magnify the impact of gilt investments. This means they can use less of the pot to match liabilities and more to invest for more growth.
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Leveraged LDI uses swaps and other derivatives for this magnification effect. When these deals are done, the pension companies have to put up some cash to back them. They also agree that if the deal goes against them — so if interest rates rise or bond values fall — they’ll put up more cash.
Unfortunately, the speed of the collapse in the price of gilts gave them very few options to find the extra cash. They were forced to sell gilts, depressing the price even more, and creating a vicious circle. This is what has been termed the “doom loop”.
The Bank of England stepped in to put a stop to it by buying gilts, but that arrangement ended on Friday. The idea is that pension companies used this extra breathing space to find alternative ways free up more cash to put up against their leveraged LDI arrangements — either through selling other assets or calling on employers to increase their contributions.
Watch: When should I start paying into a pension?
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