The Bank of England was warned about a looming pension fund disaster five years before it was forced to intervene to prevent a meltdown in the bond market.
Lord Simon Wolfson, the chief executive of Next, said that his treasurer wrote to the Bank when it was governed by Mark Carney in 2017 about so-called liability-driven investment strategies (LDIs), high-risk investments that raised fears of a market-wide collapse this week.
Lord Wolfson said that his business rejected advice to invest in LDIs, and warned the Bank that they were a looming “time bomb”.
He said: “We don’t have LDIs. We not only said we wouldn’t do LDIs when we were being sold them by everyone who thought they were a brilliant scheme, we also — our treasurer — wrote to the Bank of England to say that we felt it was destabilising.”
LDIs are intended to ensure that a pension fund always has enough money in its investments to cover the amount that it owes to its members — the fund's liabilities.
They do this by using complex financial instruments known as swaps, which pay out when the returns on government bonds fall so that the pension fund still has a predictable income.
However, in order to access these products, the fund has to put up cash as collateral to prevent the risk of a sudden sharp swing in the market causing unsustainable losses for the investment bank providing the swap, called the counterparty.
A massive plunge in the price of 30-year bonds this week triggered a wave of so-called margin calls in which the funds' counterparties demanded extra collateral because of the scale of the sell-off.
To provide this money, pension funds were forced to sell investments - mostly more 30-year bonds. This sent the price down even further and triggered a vicious cycle that would have sparked collapses had the Bank not stepped in.
As a result, Threadneedle Street was forced to intervene and buy £65bn in long-dated gilts.
Economists compared the crisis to the run of withdrawals that led to the collapse of Northern Rock in 2008.
The LDI issue that led to the Bank’s emergency intervention on Wednesday points to a blindspot at Threadneedle Street that goes as far back as when Carney was Governor, working alongside then-Chancellor Philip Hammond.
The Canadian banker is a man who likes to position himself at the centre of events. The morning after the Brexit vote in June 2016, he addressed the nation from a podium in Threadneedle Street in a bid to reassure markets.
Even this week, two and a half years after leaving the Bank, Carney was happy to chime in on the chaos that ensued following Kwasi Kwarteng’s controversial mini-Budget. He accused the government of “undercutting” Britain’s key economic institutions and arguing that its debt-funded tax cuts were "working at some cross-purposes" with the Bank.
Yet alongside the warning from Next in 2017, the Bank’s own officials said a year later that LDIs risked triggering a pension market crisis.
In its financial stability report in November 2018, the central bank identified the hazard of “potential calls on collateral that could arise in a stress” from LDIs.
It added: “It is not clear whether pension funds and insurers pay sufficient attention themselves to liquidity risks. For example, initial work by Bank staff has found that some insurers may not be recognising fully all the relevant liquidity risks”.
The warning was issued in an era of low and often falling bond yields — benign conditions for this corner of the market. However, too few funds heeded the Bank's concerns.
That set the stage for the meltdown this week, when the liquidity crunch sparked a near-disaster.
The Bank in 2018 said it intended to work with the Prudential Regulation Authority, the Financial Conduct Authority and the Pension Regulator “to enhance the monitoring of the potential liquidity demands and losses generated by non-bank leverage”.
It added: “If it is found that risks reach systemic levels, further action should be considered.” However, it is unclear what the result of this research was or what actions, if any, were taken.
One analyst also sounded the alarm over the summer about LDIs as gilt yields ticked higher.
In July, Calum Mackenzie, a partner at Aon Investments, said: “The seemingly sedate worlds of bonds and liability hedging have been rocked by the sort of rises in yields that we have not seen for decades.
“If trustees can’t fulfil the collateral call, their LDI managers will be forced to cut their hedge, which would expose the scheme to the interest rate risks they were aiming to eliminate.
“If we were to see even more volatile market movements, schemes would lose their hedge and then be victims of yields — meaning their liabilities would shoot back up while the assets wouldn’t keep pace. At a minimum, a stress-tested and planned collateral strategy is essential as preparation against further volatility.”
However, the extent to which LDIs could disrupt the wider financial system was not understood, according to industry veterans.
John Ralfe, a pensions expert, said: “What the last few days have shown is that individual UK pension schemes and the system as a whole have far more hidden risk than we thought.
“There is a systemic risk in the UK financial system that nobody was doing anything about — it’s not been properly regulated.”
The LDI market has grown rapidly in the last decade and now totals almost £1.6 trillion, according to the Investment Association. In 2011, it was only worth around £40bn.
Lord Wolfson’s decision not to tie up Next’s pension scheme in these products now looks like a shrewd one.
He said: “What we were being encouraged to do at the time, which we rejected, we were being encouraged to invest money, our pension fund money, into index linked bonds and then use those index linked bonds as security to borrow money on floating rates and buy more index linked bonds at a time when index linked bonds were value destructive — so there was always a time bomb.”
However, others have defended the investment strategy. Mark Wiedman, a top executive at BlackRock, blamed the “turbulence induced by policy decisions” on the market chaos rather than on LDIs.
Speaking at a conference in New York organised by the Financial Times, Mark Wiedman, head of international and corporate strategy at the world’s biggest money manager, said LDI investing was going through “adolescent pains” and that the long-term case for LDIs is “actually really powerful”.
He added: “Here what we have is a relatively sleepy market that has had very few shocks, including during the financial crisis that’s suddenly going through turbulence induced by policy decisions.”
The amount of government bonds held by pension funds varies, but disclosures show that the Universities Superannuation Scheme, which manages the pensions of 460,000 university lecturers, administrators and other staff, held around £34.4bn in government bonds by the end of last year. The BT Pension Scheme, the UK's biggest corporate pensions scheme, holds around £15.1bn of gilts.
Funds do not disclose their level of exposure to LDIs.
Simon Pilcher, CEO of USS Investment Management, said: “Navigating current market conditions has been challenging, and has required much management action over recent days.
“What became clear on Monday was that we were in a very disorderly market, most particularly in index-linked Gilts – with levels of volatility we’ve not seen in at least 35 years.
Pilcher added that the Bank’s intervention was “warranted and timely”.
“We continue to monitor these markets very closely and will ensure we are resilient to further challenges,” he said.
Markets calmed somewhat on Thursday with yields on 30-year gilts settling just below 4pc. Although the Bank’s intervention settled markets and bought time for pension funds to top up their collateral levels in a more orderly fashion.
Ralfe said: “The problem has gotten less bad since the Bank’s intervention but in absolute terms there is clearly still a problem.”
Lord Wolfson said: “In the drive to eliminate all risk, if you look at what LDI is all about, the aim was to completely eliminate all risk from pension funds and to get out of equities, which over the long run deliver higher returns than bonds, and into fixed interest index linked bonds and that has been the push for the last 15 years.
"What it does, the effect of that is to reduce the volatility of your valuation of any pension fund in any one year but the view we took at the time and the view we still take, long term it doesn’t reduce risk, and I think that’s what we’re seeing at the moment.
"I do think the whole way in which we address long-term risk in pension funds and the balance between long-term risk and short-term volatility risk needs to be threaded very carefully because I think the mistake people make, they thought eliminating volatility was exactly the same as eliminating risk, but because the liability of a pension fund is long term, actually short term volatility shouldn’t matter. That was our view."
Ralfe says that there should be an inquiry into how the Bank and the Treasury almost allowed a full blown pension crisis to occur.
While Carney was happy to lambast the government for creating chaos in financial markets, he and Andrew Bailey, the current governor of the Bank, might have questions of their own to answer about the LDI implosion that almost triggered a full market meltdown.