Urgent warnings ignored and regulators asleep at the wheel: Growing fears that Gordon Brown’s pensions timebomb may finally be about to explode

  • At the last count, Universities Superannuation Scheme (USS) had £82 billion
  • One of Gordon brown’s first big changes was to axe a dividends pension perk
  • The cost to British pension funds was around £100 billion over the decade 
  • An economist this week said it was known this would screw pension funds
  • But they said it would take 20 years to be noticed and ‘hey presto, it happened’

To understand the crisis that has torpedoed financial markets, you need to start on Threadneedle Street in the City of London. Not at the Bank of England, with its magnificent domed roof and pillared, 18th-century facade, but at the ugly modern skyscraper directly next door.

The steel-and-glass building is where Britain’s biggest pension fund, the Universities Superannuation Scheme (USS), looks after the retirement funds of roughly 460,000 people who work, or have worked, in our country’s higher education system.

Here, in an air-conditioned suite of offices on the sixth floor, a truly astonishing quantity of financial assets are funnelled through the global financial system on a daily basis.

At the last count, USS had no less than £82 billion — that’s eighty-two thousand million pounds — under management.

To put that number in context, it’s greater than the GDP of Bulgaria or Luxembourg, or a host of small European nations.

Not to mention half of Africa.

To understand the crisis that has torpedoed financial markets, you need to start on Threadneedle Street in the City of London

Pension funds provide a huge, almost unimaginable chunk of the cash that sloshes around the world’s markets, underpinning and fuelling our economies.

In the UK alone, they look after assets worth the thick end of £3 trillion.

Put simply, if organisations this gargantuan start to fall sick, everyone will catch a cold.

Yet while recent years have seen governments regulate and stress-test investment banks to within an inch of their lives, to avoid a repeat of the devastating 2008 financial crash, pensions have been left comparatively untouched.

As we are now discovering, this has allowed them to pursue far riskier strategies than they traditionally had appetite for. Some of the complex investment strategies they have chosen are now starting to unravel, which could have terrifying consequences — perhaps as destabilising as the last great meltdown 14 years ago.

So how did we get here? Who is to blame? And, most importantly, can it be fixed?

In many ways, this is a story about people. Which brings us back to the Universities Superannuation Scheme in its skyscraper and its chief executive Bill Galvin.

A balding 54-year-old with thick-rimmed spectacles, he makes an unlikely power-broker.

Yet he can be fairly described as one of the architects of the modern pension industry.

Galvin’s CV reads as follows: as a civil servant at the Department for Work and Pensions (DWP) during the New Labour era, he was among those who devised the ‘policy framework’ under which retirement funds were required to operate.

Then, as chief executive of The Pensions Regulator, he was responsible for making sure those rules were correctly followed.

Finally, after moving to the universities scheme a decade ago, he got a chance to play the market he’d helped create.

Galvin’s CV reads as follows: as a civil servant at the Department for Work and Pensions (DWP) during the New Labour era, he was among those who devised the ‘policy framework’ under which retirement funds were required to operate

It has been nothing if not lucrative. Last year, Galvin was paid £481,760 in salary and benefits, plus a bonus of £108,271 and another £47,153 in lieu of pension.

The previous year, those figures were even higher, adding up to a combined £747,589.

Not bad for a bloke who, in his previous public sector role, had to scrape by on a mere £140,000 a year.

Yet with great power comes great responsibility. And when the historians of tomorrow sit down to write the story of the coming global financial crash — an event that many, sadly, believe is now all but inevitable — a special chapter must be devoted to the role of people such as Galvin, not to mention the organisations he has run.

It was, as we shall see, thanks to the DWP’s stewardship of the economy during his spell there that pension funds first began dabbling in the now-notorious leveraged ‘Liability Driven Investments’ (LDIs) — financial instruments used to borrow against assets in the pension fund — that came within a whisker of blowing up the entire UK bond market earlier this month.

This forced the Bank of England to intervene with a £65 billion package, led to the implosion of Kwasi Kwarteng’s mini-Budget (and Chancellorship) and has created a political crisis that is still playing out.

It was also Bill Galvin’s Pensions Regulator which sat idly by while this once little-known investment strategy quietly ballooned into a vast repository of normal Britons’ wealth, with LDIs growing in value to around £500 billion by 2013, when Galvin left.

Finally, it was funds such as USS that continued pouring ever-growing proportions of their cash into LDIs, increasing that £500 billion to a staggering £1.6 trillion —creating a behemoth that was, as the old saying goes, way too big to fail — even as whistleblowers began raising increasingly frantic warnings about their safety. Very clear those warnings were, too.

As recently as February, for example, the vice chancellors of three of Britain’s leading universities, Oxford, Cambridge and Imperial, whose employee pensions are administered via the USS, took the extraordinary step of writing a joint letter to Galvin to warn him that plans to dramatically increase exposure to LDIs would ‘import significant risks’, especially if interest rates and inflation continued to rise. Which of course they did.

Eight months later, fear stalks the markets. We have just endured a second consecutive week in which UK government bonds have remained in a state of chaos, crashing the pound, and sending ordinary people’s mortgage rates soaring.

Shares are cratering, with the domestically-leaning FTSE 250 lower by around 30 per cent so far this year. Inflation is biting hard. And a cost of living crisis fuelled by soaring gas prices is about to tear another large hole in the pockets of not just consumers but also the Exchequer which, after two years of throwing money at Covid, must now subsidise the Government’s staggeringly expensive fuel price cap.

Little wonder investors are in panic mode, desperately trying to insulate themselves in case another corner of the financial market blows up, with pensions in the front line.

The journey to this point began in the late 1990s, when New Labour came to power and Gordon Brown gained control of the nation’s purse strings.

One of his first significant changes was to axe a perk which allowed pension funds to receive dividends on investments free of tax. It was a subtle way to raise cash, which therefore didn’t hurt his party at the ballot box. But the cost to British pension funds was around £100 billion over the ensuing decade. ‘People said at the time that this would eventually screw pension funds, but that it would take 20 years until people noticed,’ is how an economist who advises some of the world’s largest institutions put it this week. ‘That 20 years is now up. And, hey presto, it’s happened.’

Also under New Labour, accounting rules were introduced forcing companies to report assets sitting in their pension schemes along with the predicted liabilities.

In many cases, this calculation unearthed enormous shortfalls. At one point in the 2000s, four out of five schemes appeared to be underfunded.

Britain’s second biggest pension fund, BT, found itself a staggering £7.9 billion in the red.

Business responded in two ways. Firstly, almost every company closed its ‘defined benefit’ scheme (in which retiring workers would be paid a proportion of their final salary for the rest of their lives) to new members. Secondly, they began looking for clever ways to reduce shortfalls.

It was this that led to the creation of leveraged LDI strategies. Put simply, these revolved around gilts or government bonds, which are a sort of IOU from the UK government for money it has been loaned by investors.

Holders of gilts (named after the gold leaf on the edge of certificates of ownership) are paid interest by the government throughout the life of the loan. At the end, the entire amount is paid back.

Since gilts are considered extremely safe, the level of interest paid is often very low. But pension funds sought to boost returns from gilts — and took up leveraged LDI strategies, using them as collateral to borrow money from financial institutions.

The money raised in this way was then invested elsewhere, often in yet more gilts. Sometimes the funds would repeat — or ‘leverage’ — this process of investment several times, effectively allowing them to raise many times the standard return on capital.

The strategy appears to have been enthusiastically embraced by The Pensions Regulator, which was created via the Pensions Act 2004.

Under Galvin and several other bosses, it saw leveraged LDIs as a relatively safe way for pension funds to reduce their shortfalls without resorting to investments in more volatile products, such as equities. It was also championed by the investment industry, with firms such as BlackRock and Legal & General making huge sums of money in the process.

The journey to this point began in the late 1990s, when New Labour came to power and Gordon Brown gained control of the nation’s purse strings

Legal & General alone has profited by an estimated £80 million a year from its 42 per cent share of Britain’s LDI market.

After growing in popularity throughout the 2000s, LDIs exploded in the aftermath of the financial crisis, when interest rates and therefore gilt yields fell close to zero but pension managers were required to sweat their assets to reduce deficits.

By this year, the size of the market (which remained little known outside the pensions industry) was estimated at an astonishing £1.6 trillion, almost 13 times the size of the entire NHS budget.

What’s more, after years of relative stability in the gilt markets, with yields (or annual returns) falling close to zero during the Covid crisis, and share prices simultaneously rising, many pension funds found themselves almost fully funded.

There was, however, a problem. It became increasingly apparent that LDIs were designed in a way that would make volatility in the gilt markets very risky. For years, pension-fund trustees, many of them relative laymen, had been talked into endorsing LDI deals structured in a way that required them to find extra cash to cover the loans involved should the value of their gilts fall.

Such arrangements are known as derivatives contracts, a form of investment once memorably dubbed ‘financial weapons of mass destruction’ by the U.S. financial guru Warren Buffett. And this year, the value of gilts started to fall through the floor.

‘I can count on the fingers of one hand the number of trustees who understood the risks they were taking,’ pensions expert John Ralfe said this week. ‘They were egged on by investment advisers, who have made a fortune in recent years.’ Many smart people with market experience saw this coming. Lord Wolfson, the chief executive of Next, asked his treasurer to write to the Bank of England in 2017 to warn officials about risks associated with LDIs.

He said they’d been offered to his company but did not ‘smell right’ looked ‘very dangerous’ and were a looming ‘timebomb’.

In 2018, the Bank itself said some pension funds were not paying sufficient attention to risks of a cash crunch.

Meanwhile, one Dutch fund manager warned in 2019 they were a ‘terrible’ threat to the global economy. February’s letter from Oxford, Cambridge and Imperial to the Universities Superannuation Scheme also marked a striking attempt to raise the alarm.

But the industry ignored these naysayers, perhaps because it was financially convenient to do so. And by late September, their fears were being realised, in spades.

The trigger for the recent crisis was, of course, former Chancellor Kwasi Kwarteng’s mini-Budget, which included a colossally expensive energy price cap along with large, unfunded tax cuts. Though designed to grow the economy, it raised concerns about the UK government’s ability to pay its debts.

This coincided with the U.S. offering huge amounts of bonds on the market (they put around a quarter of a trillion dollars worth up for sale last Thursday alone), making British gilts instantly less attractive to investors.

Their value quickly dropped through the floor.

Within hours, pension funds with large LDI positions — some were leveraged six times over — suddenly found themselves in crisis. The reason? The gilts they were holding as collateral for other investments were suddenly worth significantly less, meaning they needed to immediately find cash to plug the gap.

Unfortunately, the main way they could quickly raise cash was to sell large quantities of gilts, which in turn had the effect of driving the market price even lower. That in turn created a sort of ‘doom loop’ or ‘death spiral’.

In other words, leveraged LDIs, which had been designed under the nose of regulators, and adopted by stewards of ordinary people’s pensions, were causing the entire UK bond market to fail.

Out of fairness to Bill Galvin and the Universities Superannuation Scheme, it should be stressed that they were less affected by the turbulence than many peers.

The scheme’s chair, Dame Kate Barker, says: ‘While navigating the recent market volatility was challenging, it was manageable and that is because we have adopted a conservative approach to LDI.

‘We have not been a “forced” seller of any assets through this period and the scheme’s overall funding position is stronger now than it was a month ago.’

Galvin points out, again quite reasonably: ‘Our adoption of LDI strategies has been moderate and we have been prudent in our use of leverage.’

Be that as it may, the industry and bond markets remain in a state of upheaval, despite a £65 billion package from the Bank of England.

This forced the Bank of England to intervene with a £65 billion package, led to the implosion of Kwasi Kwarteng’s mini-Budget (and Chancellorship) and has created a political crisis that is still playing out

Large amounts of taxpayer cash may eventually be required to fix them. Amid falling confidence, observers are now increasingly concerned about contagion spreading to other corners of the market.

One area of concern in the world of pensions is bulk annuities, through which trustees finance retirement payments to pensioners. Many of these are understood to be financed using U.S. corporate bonds, which are also falling in value.

In the banking sphere, analysts are worried about Britain’s exposure to Hong Kong, where financial institutions have loaned huge sums to a Chinese property market now in freefall.

The territory’s external debt is also around £400,000 per working person and should large amounts of these debts to go into default, the knock-on effect on the likes of HSBC, which is its largest bank, would be colossal.

Again, pension funds would be among the first to feel tremors.

One quick way to stem some of the bleeding would be for pensions regulators to abandon Brown-era rules about calculating and reporting pension liabilities, which drove the rush to leveraged LDI products in the first place (even the Bank of England’s own pension scheme appears to have hefty investments in the sphere).

That would allow pension schemes to funnel their huge resources into safe and, yes, boring investments.

In the longer term, pensions should also be banned from using complex financial instruments like LDIs, without very tight risk controls that allow them to survive so-called ‘Black Swan’ events. The salesmen who foisted them upon the industry must face a reckoning.

And the professionals who allowed this crisis to play out on their watch — not least Bank of England governor Andrew Bailey — ought to at some point be put out to pasture.

The terrifying truth, however, is that while gilt market chaos has exposed a genuine crisis in pension funds, no one really knows where the next disaster will strike.

The real trouble could be only just beginning.

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