The pension fund​ for university lecturers, unlike those for teachers, civil servants or NHS workers, has no government backing and is the UK’s largest private sector scheme, providing for more than 500,000 working or retired academics. It is also one of the few pension funds that still offers new members a ‘defined benefit’, meaning that the size of your pension is calculated from your salary and length of service. But in 2011, after years of watching the fund’s deficit increase, universities dramatically reduced the benefits offered to staff, so that pensions for new members are no longer tied to final salaries but are calculated from average career earnings and indexed to a less generous measure of inflation. Further changes were imposed in 2016, including a £55,000 cap on salaries included in the career average. Despite this, by 2017 the deficit had ballooned to £17.5 billion, and lecturers were told that the defined benefit scheme would have to close altogether. Waves of strikes followed and universities relented: the principle of a guaranteed income would be retained, at the cost of increased contributions. The next valuation of the fund was carried out, controversially, in March 2020, when the impact of the pandemic on market confidence was at its height. Although the deficit had dropped to £14.1 billion, the fund’s trustees again told universities that drastic changes would be required. These came into effect in April this year, lowering the salary cap to £40,000, cutting the rate at which each year of service is valued, capping index-linked increases at 2.5 per cent (just as inflation began to shoot up) and increasing employer and employee contributions to 21.6 per cent and 9.8 per cent respectively. This latest round of cuts will, according to the University and College Union, reduce entitlements by as much as 35 per cent.

I joined the scheme as a new lecturer in 1997 and, having lived through repeated cycles of deficits and cuts, had begun to wonder whether, as critics have argued, defined benefit schemes are simply unsustainable at a time when the workforce is shrinking and the population ageing. To my surprise, however, the scheme is no longer in deficit; as of 30 June, it had a surplus of £1.8 billion.

A pension fund’s deficit (or surplus) is the difference between its assets and its liabilities. It’s relatively straightforward to put a figure on the cash value of a fund’s assets but harder to express the size of its liabilities – the promises made to the fund’s beneficiaries – because these stretch into the future. Different approaches will produce different estimates. British companies are legally required to report their pension liabilities as the cost of buying enough high-quality bonds, government bonds for example, to provide the promised income to beneficiaries. One great attraction of government bonds is that powerful countries with their own currencies don’t default – if all else fails they can print the money required to meet their obligations. Another is that they pay a guaranteed rate of interest. The only problem, as far as pension funds are concerned, is that you can’t predict the interest rates on bonds the government might issue next year or the year after. If interest rates go up, then bonds already issued, which pay the old, lower rate of interest, will seem less valuable. If you want to sell those bonds you will have to accept a lower price. In a world where bonds are continually traded, it makes sense to think of the income generated by the bond as a proportion of the current rather than the initial price. Traders talk about the yield rather than the interest: if the price of a bond goes down, then since the interest it pays stays the same, the yield will go up.

In a simple world, a pension fund manager could use the contributions from employees to buy bonds, and the fund’s liabilities and assets would be perfectly matched. But fund managers have traditionally put at least some funds into riskier investments, such as stocks, to generate higher returns. The risks are manageable because pensions are long-term investments and can ride out market fluctuations. The managers of closed schemes, however, are primarily focused on balancing the books, so invest in bonds rather than stocks. In recent years they have used a strategy called Liability Driven Investment (LDI) to guard against the risk that the yields from their assets will be lower than the yields used to calculate their liabilities. A key element of LDI is hedging – for example, protecting a fund against low or falling bond yields by betting that yields will go down. If yields go up, you can buy high-yielding bonds and not worry about the bets you lost. If yields go down, you will have to buy more bonds to get the same return, but at least you have an additional income from the bets you won. For the last ten years, bond yields have stayed low, LDI has been a winning strategy and many schemes have moved into the black.

LDI is reminiscent of the financial engineering that brought about the crisis of 2008: derivatives such as interest rate swaps are assembled into packages and traded through intermediaries with names like BlackRock. It’s clear that pension funds have been making huge bets with billions of pounds that they don’t have. One of the worrying things about LDI is that in order to do the amount of hedging they thought they needed, pension funds have ‘leveraged’ their investments. For example, say I have a bond worth £10,000. Using a form of derivative called a repo I can sell it with the promise to buy it back later for, let’s say, the same amount. After the sale I no longer have a bond, but I have £10,000 in cash, which I can use to buy another bond. I now have an asset worth £10,000 and £10,000 of leverage: if the bond goes up, I’ve doubled my winnings, if it goes down, I’ve doubled my losses. To minimise the risk that the other party (typically a bank) takes on in accepting leveraged deals, funds post collateral with them and agree to post more collateral if the bets go south. It’s this aspect of LDI, the posting of collateral, that has led to the recent difficulties.

When Kwasi Kwarteng’s mini-budget sent the markets into turmoil, it became clear that interest rates would have to rise. If interest rates go up, fewer bonds are needed to generate the same level of income and pension fund liabilities fall. The problem for the funds was that the LDI products they had bought weren’t designed for such rapid increases in yields. As their losing bets came in, they were forced to post more collateral. And because this was happening faster than expected, some funds needed to post more collateral than was immediately available to them. The easiest way to raise more cash was to sell bonds, but so many funds needed to sell that prices were forced even lower. The number of available bonds became far greater than the number of buyers, which at one point was no one at all. The Bank of England was forced to step in, contributing to the sense of market chaos that caused Kwarteng to lose his job.

The Bank of England’s intervention has focused attention on LDI, and more generally on the unexpected consequences of this approach to risk management. Financial journalists have also expressed surprise at the amount of leverage the pension regulator seems to have not only allowed but encouraged. In a survey in 2019, 137 funds with assets totalling £697 billion were found to have £498.5 billion in leveraged investments. The biggest problem with LDI, however, is the role it has played in slowing economic growth. The Resolution Foundation’s Stagnation Nation report, published earlier this year, pointed out that the UK economy is suffering from a lack of investment.* Our businesses invest less in new plant, training workers and research and development than our G7 competitors. A huge amount of capital that could be used to increase productivity – roughly £1.45 trillion, or two-thirds of GDP – is held in defined benefit schemes. Fifteen years ago, 43 per cent of these schemes were open to new members; now only 11 per cent are. As a result of that change, the proportion of their assets invested in stocks – in investments that contribute to economic growth – has fallen from 61 per cent to 19 per cent, in favour of non-productive assets such as LDI.

The success of the lecturers’ strikes is reflected in the scheme’s current investment strategy. Two-thirds of its assets are used to achieve growth, a quarter is kept as credit and half is used for LDI. These numbers add up to more than 100 per cent because the excess is leveraged. Some universities are unhappy about this, but the amount of leverage, and the overall use of LDI, is much lower than in other defined benefit schemes. The scheme’s website reports that although the pension fund has had to rebalance its portfolio in the wake of the mini-budget, it wasn’t forced to sell assets. Indeed, it was able to buy bonds that others had to sell at a discount. Despite this good news, we are preparing for another round of strike action. When the forecasts showed deficits, we were told that devastating cuts were required. Now the forecast shows a surplus, we have been told that forecasts aren’t a robust basis for decision-making and that therefore the cuts won’t be reversed. The trustees could fall back on a piece of actuarial work commissioned by the UCU in 2017, which showed that the money being paid into the fund by lecturers was more or less the amount being paid out for the pensions of their retired colleagues, and that this would probably continue to be the case. The £82 billion of assets owned by the fund might scarcely be needed.

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