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18 November 2022

The Grey Recession

Pensions are supposed to be the most sensible part of the economy, but in an ageing society they are creating new systemic risks.

By Will Dunn

The atmosphere around Budget speeches is often boisterous, but when the Chancellor, Jeremy Hunt, presented his Autumn Statement yesterday (17 November), the House of Commons was relatively subdued. The only measure to attract a unanimous cheer from the Tory benches was Hunt’s commitment to the “triple lock” on the state pension, which will raise the benefit by over 10 per cent in April, meaning that for the first time the UK pays everyone over the age of 66 more than £10,000 per year.

The UK, like the rest of the world, is getting older. Two days before Hunt’s speech, on Tuesday 15 November, the UN announced that the world population had reached an estimated eight billion people. While the birth rate is slowing, populations continue to rise because people are living longer; almost 30 years longer, in fact, than they did when the UN began collecting data in 1950. For Hunt, and for every chancellor from now on, a key problem in the economy is how to support a growing population of retirees using a shrinking population of workers.

On the afternoon of 26 September, this problem brought the UK economy to the brink of disaster. Throughout the day, officials at the Bank of England had received calls from pension fund managers who warned that they were preparing to sell off assets – mostly government bonds, or gilts – worth tens of billions. The Bank’s economists knew that if this happened, it could cause a run on pension fund assets; Jon Cunliffe, the deputy governor, saw “widespread financial instability” as the likely result: the plumbing beneath the pension system threatened to give way. At stake were the retirement savings of millions of people, and the government’s ability to borrow and spend on public services.

That night, the Bank’s analysts and policymakers stayed at Threadneedle Street to prepare a market intervention, which they announced the next morning: to soothe the market’s fever, they would buy up to £65bn in gilts. At the same time, the Conservative Party was preparing its own intervention: within a month it had replaced first the chancellor and then the prime minister.

How did this happen? The quick answer is that, as in previous financial crises, the people whose job it is to provide returns to investors in financial markets did something that looked very clever, until it exploded in their faces. The longer and more detailed answer is that, as in previous financial crises, the system itself leaned towards disaster. Like the overheating climate, the ageing society is no longer an academic problem: it is here, and the failure to confront it is becoming evident in ever-more frequent crises.

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Defined benefit (DB) pensions, also known as final salary pensions, are part of the bedrock of the UK’s financial system, the cushion on which the baby boomer generation had always planned to settle itself: £2.5trn squirrelled away for the purchase of elasticated trousers and cruise holidays. Pension funds account for 42 per cent of wealth in the UK, eclipsing even the country’s housing stock as the single-largest component of assets. 

When these pensions began to be offered to workers in the 1970s and 1980s, they were a collective solution to an individual problem: the financial risk of living longer. It’s a perverse kind of risk, given that this is something we all hope will happen, but it exists because we also hope to stop working one day. Because no one can say exactly how long they’ll live (and therefore how much money they’ll need in retirement), it makes sense to share this risk with others, and offer everyone a set amount (a defined benefit) for as long as they live.

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But they were also a political solution: as life expectancies rose, the cost of the state pension would rise too. “Mrs Thatcher could see the demographic problem coming,” says Martin Weale, who was an academic economist at Oxford at the time, before becoming director of the National Institute of Economic and Social Research. “Her solution was to index pensions in line with prices instead of wages [at that time, wages grew more quickly than prices]… and assume that people would make their own arrangements to top up their pensions”.

In the decades that followed, successive governments did more to make private pensions the default option. The Pension Schemes Act of 1993, the Pensions Act of 1995, the introduction of the Pensions Protection Fund and the Pensions Regulator were all designed to reassure savers that a private pension would remove the risk of poverty in old age.

But risk is like energy: it can’t be destroyed, only passed on to another body – in this case the businesses that provided the pension schemes. Company boards stared at their balance sheets and were confronted by deficits – the estimated gap between the assets they had in the pot and the liabilities they’d one day have to pay out, and the uncertainty of maintaining these amounts for decades to come.

At this point, many companies came to realise the fundamental truth about the ageing economy: that it will not be possible to support an ever-growing number of wealthy retirees with a dwindling population of workers. In the early 2000s, almost all DB schemes were closed to new members. The children of the defined-benefit generation would, like their grandparents, shoulder the risk of retirement income themselves.

In the meantime, DB funds still faced the challenge of investing the assets they had so that they would be the right size when they were needed. The majority of funds had put most of their members’ money in what are generally regarded as the safest assets in financial markets – government bonds, such as US Treasuries and British gilts (so named because their certificates were once edged with gold leaf).  

A bond can be thought of as an IOU. The buyer lends the issuer money (the price), and gets a fixed return (or coupon) until, at a fixed date, the initial sum is paid back. For a pension fund a long-dated bond, such as a 30-year gilt, is a sound investment because it will produce a fixed return for decades to come, and the UK hasn’t defaulted on its debt since before it began issuing bonds in 1694. For this reason, more than a quarter of Britain’s national debt is owned by pension funds and insurance companies. 

The problem with gilts is that the returns they generate aren’t typically that high, especially when interest rates are low. So from 2003 onwards, pension funds began using other investments designed to insure their assets against changing interest rates. These were derivatives, which can be thought of as a contract, or a side bet, on the value of an investment. Using derivatives such as interest rate swaps and repurchase agreements, powered up by borrowing (known as leverage), fund managers were able to construct strategies that meant their assets would grow predictably until they met all their liabilities just when they needed to. They called this “liability-driven investing”, or LDI. 

LDI quickly became a big business. A few people observed that using leveraged derivatives to speculate on apparently rock-solid assets was something that had been tried before, most notably in the years building up to 2008. Simon Wolfson, the Conservative peer and chief executive of the retail chain Next, warned the Bank of England in 2017 that LDI was a “time bomb”; he remains critical of it.

But the trend had already taken off – the Bank’s own staff pension scheme was already using LDI – and between 2003 and 2022 pension funds, mostly DB pensions, committed £1.5trn to LDI strategies in the firm belief that the structure would take care of itself, unless something really exceptional happened.

And then, of course, something exceptional happened. 

[See also: The UK’s rising inflation rate has a hidden cause: corporate greed]

Kwasi Kwarteng’s mini-Budget on 23 September is a contender for the most expensive speech ever delivered in the Commons: a recent report by the US investment bank, JP Morgan, puts the costs incurred by pension funds at £75bn.

In what the short-lived Liz Truss government called the “Growth Plan”, Kwarteng outlined £45bn a year in tax cuts that would, like the government’s £150bn energy plan, be funded by new borrowing rather than taxes (Truss argued “you can’t tax your way to growth” when she announced the policy). The government borrows money by issuing bonds, so in financial markets this amounted to a plan to sell up to £200bn in gilts.

If De Beers suddenly released £200bn of stones on to the diamond market, we’d be using them as paperweights. The effect on bond markets was not dissimilar. A torrent of supply threatened to destroy demand, prices fell and yields (which move in the opposite direction, and determine how much it costs to service the debt) rose sharply. The problem was compounded by the fact that a day earlier, the Bank of England had itself committed to begin selling off large amounts of the very same product because, after a decade of quantitative easing (QE), its Asset Purchase Facility holds £841bn in gilts.

Pension funds had not factored a change of this magnitude into their plans. LDI was no longer an insurance policy; it was a threat. Tony Yates, the former head of monetary policy strategy at the Bank of England, says that decades of “wise, conservative pension regulation” had unintentionally created “this other, almost system-threatening problem”.

The derivatives used by LDI became very expensive, very quickly. The leverage that had made them a good bet now made them a huge cost. Fund managers across the City began to receive “margin calls”, phone calls asking them to top up the collateral – the cash pile used to pay out when derivatives lose money – in their LDI accounts.

The big problem for pension funds using LDI was that they had already put this fire out once, when markets began to price in Truss’s policies. The emergency cash had been spent, and when gilt prices started to collapse on Monday 26 September, they faced new calls for hundreds of millions of pounds. Even a pension fund doesn’t have this much cash just lying around. “The sheer speed of the move didn’t give any time to put into effect the plans that had been developed to move assets and replenish collateral,” says Dan Mikulskis, an investment adviser to pension funds.

It began to look as if the only options would be for pension funds to begin selling off some of their most commonly held and most liquid assets: government bonds. Had they done so, yields would have spiked even higher, leading to more margin calls and forcing even more bond sales. The rush for liquidity began to threaten solvency – what Yates calls the “classic run problem” that every banker dreads. There was a risk of contagion, as a massive sell-off by pension funds could have impacted the values of assets held by other financial institutions.

The outcome was swift and brutal: within a fortnight a new chancellor, Jeremy Hunt, had swept aside almost all of Truss and Kwarteng’s economic policies, and within a month Truss herself was gone. The bond markets’ violent rejection of fiscal policy had forced Downing Street and Threadneedle Street to reorient themselves to protect the pensions of 9.7 million older people, 4.2 million of whom are already retired. 

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The thing is, Liz Truss was right to say that the UK economy is starved of growth. The UK has the lowest business investment in the G7, trade is 25-30 per cent below the pre-Brexit trend, and we are the only G7 economy in which growth has not recovered to pre-pandemic levels. Truss thought this was because businesses pay too much tax, but the headline rate of corporation tax makes little difference. If it did, Hungary (which taxed companies at 9 per cent before last year’s global agreement on corporation tax) would be a powerhouse in comparison to the United States (which taxed them at almost 40 per cent until 2017). In the UK – where most businesses are small firms and sole traders – most companies don’t even make the £50,000 a year in profit needed to pay corporation tax in the first place.

Britain’s slow growth may have more to do with where its money ends up. Decades of prudent conservatism – tax breaks and incentives to save into pension schemes and buy houses – have inflated asset prices and locked trillions into unproductive capital. DB schemes invest just 11.6 per cent of their assets into UK-quoted equities: this is the most responsible thing for them to do on behalf of their trustees, but it also means that when British companies want to hire new people or develop new products, and need new capital to do so, the UK’s biggest investors are unlikely to provide it. An important and overlooked question, says Mikulskis, is: “Who are the growth investors in the UK economy?”

Meanwhile, the demographic problem that Thatcher spotted remains unsolved. Growth and investment from abroad are limited by Britain’s creaking infrastructure – transport, energy, information and healthy, well-educated workers are all largely the product of public spending and long-term capital investment in R&D and infrastructure. The UK is hampered by the huge chunk of public spending (more than £115bn in 2021) that goes on the state pension, a benefit paid to almost everyone from age 66. There is no fund for this, no pot of assets to support it; it is simply paid for by today’s (and tomorrow’s) taxpayers.

We may fret about the £2.4trn national debt, but this is actually reduced by inflation. Our public sector pensions liabilities are hundreds of billions of pounds larger and when inflation rises, they rise too; Truss’s last act in government was a commitment to raising the state pension by 10.1 per cent, in accordance with the triple lock, which increases pensions each year by 2.5 per cent, average wage growth or consumer price inflation, whichever is greater.

But while realists recognise that at some point the triple lock will have to fall – both Jeremy Hunt and Lisa Nandy, the shadow minister for communities, refrained from committing to it for the long term – no one wants to be in the government that makes this decision, because more and more people are going to be more and more reliant on the state pension.

Plot a graph of what the UK’s pensioners will receive over time, as the generous DB schemes wind up and people become reliant on defined contribution (DC) schemes, and you get what the former pensions minister Steve Webb – not someone given to hyperbole – described in a report for the pensions consultancy Lane Clark & Peacock as the “ski slope of doom”. In the DB era, companies and employees paid on average more than 25 per cent of earnings into pension pots, with a guaranteed and indexed income at the end. The average worker now pays 8.9 per cent into their DC scheme, and when they retire, they’ll get what they get.

“We may have created a situation,” says Martin Weale, “where people think that because they’ve joined the scheme, they’re going to get a comfortable retirement. And when the future comes, they will discover that what they’ve got doesn’t buy them very much.”

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For today’s retirees, however, it’s a different story. The political, economic and cultural power of older people has never been more evident: this year’s Glastonbury festival was headlined by Robert Plant (74), Paul McCartney (80) and Diana Ross (78). Donald Trump was the first US president to take office aged over 70; this month, Joe Biden will become the first to remain in office beyond 80. (Biden’s first presidential campaign took place when Rishi Sunak was eight years old).

Pensioner poverty has fallen to a third of its peak in the 1980s, and one in five over-65s now lives in a household with a wealth of more than a million pounds. By 2015, pensioners were on average the highest-earning group; the UK had become a country that pays people more to be retired than it pays them to work. Steve Webb notes in his report that men retiring in the early 2020s “will probably have the highest incomes of any generation before or since”, thanks to their DB pension wealth.

Meanwhile, levels of relative poverty among working households have never been higher (as measured by disposable income). Young children today are more likely to face poverty than any generation for 60 years. We spend tens of billions more on pensions (£115bn) than we do on education (£76bn), and a significant portion of this spending goes to people who barely notice it.

This is partly the result of the postwar baby boom. “The massive demographic and political weight of that generation has helped make sure that it is protected over time,” says Bobby Duffy, director of the Policy Institute at King’s College London and author of Generations.

The personal wealth of this generation, and the policies that have sought to protect it, have reshaped our society. Multi-generational households, once common, have been reformed into what Duffy calls “beanpole” families. As people in their thirties and forties age without building up assets, families themselves are declining – increases in house prices and rents have been shown to reduce the birth rate. They are also moving physically apart. In rural constituencies such as North Norfolk the median age now approaches 55, while in urban centres such as Cardiff and Sheffield it is only slightly over 25.

Britain’s old live in another country to the young, and this is why one half makes decisions that the other cannot fathom, such as banning solar farms, or leaving the EU. Meanwhile, “boomer” has become a pejorative thrown around by internet contrarians bidding for the approval of disenfranchised millennials.

These divides will not disappear as the generation now in retirement fades away. The inequality between generations is becoming “baked in”, says Duffy, and Britain is turning from a mostly meritocratic society to one in which, as it was in the past, familial wealth becomes the most crucial element in a person’s economic prospects.

The funding of old age is not an insoluble problem. Britain’s financialised and unequal economy, its overheated property market and its tax system, which rewards ownership over industry, are all the results of political choices that are reversible. Free movement could supply younger workers; benefits could be given to those who actually need them. But to do that would take significant political courage, and this was lacking from Jeremy Hunt’s economic plan.

Britain remains an economy on the path to senescence, one that will need increasingly strong doses of monetary stimulants and fiscal surgery to remain on its feet: a country in which the work of the future is subordinate to the wealth of the past.

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