Eli5: why did the UK pension market nearly collapse?

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I know it’s got something to do with government bonds but I don’t understand the mechanics.

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3 Answers

Anonymous 0 Comments

Those in charge of monetary policy announced changes that panicked the market and sent it down very quickly. Because it was falling so quickly there was risk that pensions that invest both money they are given and money they borrow would be required to pay back the borrowed money immediately. This is known as a margin call.

Pensions typically invest in assets that are less risky but that also means they typically cannot be turned into cash quickly which is necessary if you need to pay off margin. If you get margin called and cannot pay back your debt the rest of your assets are liquidated at the current market rates until your debt is fulfilled. This means huge losses to those who had their money in the pension funds.

The Bank of England wanted to head this off and so they said they would prevent it from happening by buying as many bonds as needed to keep the pensions safe.

Anonymous 0 Comments

Pension funds want to provide fairly low risk investments, but also reasonable returns (profits). They are the major buyers of gilts (UK government bonds) because these are low risk. But the returns aren’t good enough, so they also buy other financial products. Naturally these products are higher risk, so the pension funds want to hedge (insure against) that risk.

They do this by what is called leveraged hedging: effectively they borrow money to buy gilts. This exposes pension funds significantly to gilt values. If a fund borrows money to buy a gilt, then when the loan falls due the gilt is worth less, it cannot cover the debt by selling the gilt.

This led to a runaway effect of pension funds selling gilts to reduce their exposure to falling prices, further reducing prices.

The issue is not so much of the pension funds running out of money overall, but of them running out of liquidity. If a fund doesn’t have enough cash to pay off the loans that are falling due (or equivalent financial instruments) then they have yo sell their gilts and that precipitates the crash.

Anonymous 0 Comments

Pension systems generally work by having a large retirement fund for all employees instead of many smaller ones. When the bond market tanks, though, the returns from those investments is insufficient to pay what they need to.