Why Government Borrowing Matters to Pension Funds

Published / Last Updated on 05/10/2022

Why did the Bank of England start buying back gilts to protect pensions funds this week?

When the British government borrows money, mostly fixed interest rate borrowing with a date to repay to date in say 20, 25 or 30 years (just like an interest only mortgage),  It issues ‘gilt edged’ securities.  Overseas, they are known as government bonds or sovereign bonds.

Pension Funds and Gilts

Much government borrowing is from pension funds.  Pensions funds ‘lend’ your pension money to the government as it is deemed secure, a guaranteed income for 20 or 20 years and then the original debt capital is repaid in full.

Many pension schemes offer a ‘fixed rate fund’ or an ‘index linked fund’ and some of this money will have been invested/loaned to government for a safe return.

Most pension annuity income providers use your pension fund, then buy gilts to give them a secure income which they then use to guarantee you a secure fixed or inflation linked pension annuity income.

Bigger company pensions such as defined benefit final salary and career average salary schemes only offer a tax-free lump sum and a guaranteed income in retirement.  They too lend the government £billions for a safe, income/return to allow them to protect their liabilities to pay you a guaranteed pension for life.

Interest Rates and Gilt Market Crash

When bank interest rates increase, the capital value/market value of a gilt falls but the fixed income being paid is the same, it is guaranteed.

  • E.g., You buy £100 gilts paying 2% pa fixed interest i.e., £2 pa.  Bank interest rates are 1% pa, so you are getting a 1% better interest from gilts than leaving your money in the bank.
  • The Bank of England increases interest rates to 2%.  Your existing Gilt (face value £100) is still paying £2 pa fixed.  This is now less attractive as an investor may as well just put their money in the bank.
  • If an investor wants to maintain a 1% pa over bank interest rates return (now 2% pa) with Gilts rather than the bank, they will want a 3% pa return (1% over base rates).
  • To get a 3% return on your £100 face value gilt paying £2 pa, an investor would only pay £67 for it.  £67 cost for a £100 face value gilt paying £2 pa is a 3% if you pay £67 for it.
  • Gilt market values therefore fall when interest rates rise.

Mini Budget Impact

In addition, Kwasi Kwarteng’s mini budget with tax cuts and no released plans on how this would be funded sent the markets into panic in the British Government’s ability to manage the economy properly or having enough money to service its gilt debt.   Gilts values were pushed down even lower.

Whilst this makes it cheaper for pension funds when buying new gilts to then guarantee pensions and annuities, the fall in market value of existing gilts puts the capital adequacy and funding position of larger pension funds in danger.  Imagine you run a large pension fund and part of your portfolio that was worth £100 for each gilt, and they are now worth £67, a fall of 33% in a few days, they would panic.

Bank of England Intervention

This why the Bank of England stepped back in with quantitative easing to buy back gilts to create shortages in the market and push gilt capital values back up thereby releasing pressure on pension funds.

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