The majority of pension savers are either immune to the recent market devastation or will be able to weather the storm given the time.
Those who are close to or at retirement age and have a hole in their savings are the most severely impacted, though they may be able to restore the harm by modifying their plans or waiting until the current uproar calms.
People in traditional final salary pension systems, which the Bank of England intervened to protect following the government’s terrible mini-budget – much of which has already been reversed – are in the safest position.
Modern defined contribution pension investors have experienced stock market losses recently, but unless they are nearing retirement when a portion or the majority of their funds are often switched into bonds, they are unlikely to have suffered losses in that quarter.
It is too early to know whether the dismissal of Chancellor Kwasi Kwarteng would calm financial markets, particularly those trading UK government bonds; nevertheless, there are early indications that the reversal of several of yesterday’s statements has helped.
Here, we provide a detailed explanation of the repercussions for bond investors, and in the sections that follow, we examine how it impacts participants in various types of pension plans.
Final salary pensions
Gold-plated and substantial final salary pensions give a guaranteed income to investors until death and often continue to pay a reduced amount to survive spouses.
During the present market crisis, the Bank of England’s high-profile action to support final salary pension systems has received considerable attention.
This is because they are extensively engaged in bonds, specifically long-duration gilts, but some were obliged to sell due to exposure to dangerous hedging tactics known as “liability-driven investments.”
The pensions of regular members, however, are secured because they individually carry no investment risk. Even if the worst occurs and their plan fails, the Pension Protection Fund will save their pensions.
Despite short-term cash flow concerns caused by LDIs, the recent movements in the bond markets will have improved the financial condition of many final salary pension plans.
Bond yields or returns have increased as their prices have fallen during the latest sell-off.
Although the pension world was shaken by the news that LDI strategies struggled to deal with a sudden, rapid decline in gilt prices, there is unlikely to be a direct impact on a pensioner in a defined benefit scheme, either before or after retirement,’ says Rob Morgan, chief investment analyst at Charles Stanley.
‘The firm or institution supporting the plan may need their pension manager to adapt the investment strategy, or they may need to invest more money in the short term, but the pensioner’s income guarantee remains unchanged.
A rise in gilt yields helps the long-term financial position of many schemes, whilst causing a short-term bottleneck for those utilizing LDI.
AJ Bell’s head of investment analysis, Laith Khalaf, says: ‘Defined benefit pension schemes are at the center of the current problem, but there are multiple layers of protection that ensure individual members are not at risk.
‘These plans are regarded as ‘gold-plated’ because not only are they lucrative, but they are also guaranteed by the pension member’s company or former employer.
Therefore, even if the pension scheme has sufficient assets to satisfy its responsibilities, it might ask the employer to contribute additional funds.
‘It’s also important to note that scheme funding has improved significantly over the past year, as while assets have declined, liabilities have declined much more.
‘According to the most recent tally from the PPF, four out of five plans had surpluses, while the remaining scheme had a deficit of only £14.3 billion. In contrast, a year ago, almost 40 percent of schemes were collectively in deficit to the tune of £116 billion.
Contribution-based pensions
Employer and employee contributions are pooled and invested to create a pot of money for retirement in defined contribution pensions.
Unless you work in the public sector, they have mostly supplanted pensions based on a final wage.
Individuals participating in defined contribution plans must assume all investment risk when developing their retirement savings.
The vast majority continue with their employer’s “default” fund, which is invested in equities, which are considered a higher risk, but better return investments over the long run, as opposed to bonds for the duration of their working lives.
However, older workers nearing or on the verge of retirement were vulnerable to the current turmoil in government bond markets and consequently experienced losses.
This is because, towards the end of their working lives, depositors in these plans are frequently gradually transferred into bonds, which have historically been considered as the “safer” alternative, a process known as “lifestyle” or “de-risking.”
By purchasing an annuity that delivers a guaranteed income, or, more typically these days, by utilizing an invest-and-drawdown program, the goal is to shield investors against sudden market downturns when they are about to begin withdrawing from their pensions.
According to AJ Bell’s Laith Khalaf, employees whose pension plans use annuity hedging funds have suffered disproportionately large losses, yet have little or no time to restore their retirement assets.
He adds, however, that investors in lifestyle schemes are unlikely to have suffered the full force of bond losses, as they are typically switched into them gradually and there is typically a cash component as well.
Moreover, some modern defined contribution plans de-risk the default accounts of savers before retirement but may retain a sizable allocation to equities because so many people remain invested in old age.
Regarding the majority of people of working age who have many years till retirement, Khalaf states, “Defined contribution pensions may include some bonds, but they will be predominantly invested in stocks, except annuity hedging funds.”
This indicates that their exposure to the gilt market is often minimal. This year’s bond sell-off has been matched by dropping share markets, and as a result, most people’s pension pots will be less than they were at the start of 2022, despite a lengthy period of growth.
This is merely the typical ebb and flow of markets, so there is no need for alarm, especially considering that pension savings are long-term and get regular monthly contributions, which are currently being invested at reduced prices.
Rob Morgan of Charles Stanley states, ‘As both bonds and stocks have declined in value this year, the majority of people’s pension values have declined.
‘This is not an issue for individuals who have many years until retirement.
‘Continuing to contribute consistently, adding tax relief and your employer’s contributions to your workplace scheme, will result in you accumulating assets at lower levels, and you will reap the benefits of your investment returns compounding over time.’
Senior personal finance analyst Sarah Coles states, ‘If you have a defined contribution pot and retirement is a long way off, you may not need to make any changes.
‘Year-to-date, default funds (where your money goes if you don’t decide where to invest) in the ‘growth phase’ have declined, but this is to be expected.
You should verify that the default fund satisfies your needs, but there’s no need to act quickly.
What options do you have if you are nearing retirement and have bond losses?
If you have a long-term perspective, you can ride out the current market volatility, argues Khalaf.
However, you must be prepared for increased volatility, particularly if you shift out of bonds and into riskier stock markets to compensate for your losses.
Nothing can prevent a 20% decline in equity markets during the next year, he warns.
Khalaf suggests that a second alternative is to purchase an annuity, given interest rates have just increased significantly.
According to him, if you take this course of action, you are likely to break even, therefore in this regard, annuity hedging funds have performed as intended, with their losses offset by more generous annuity rates.
Khalaf notes that another alternative is to “mix and match” by purchasing an annuity with a portion of your savings and investing the remainder. Learn more here about similar tactics.
Morgan suggests, if possible, working a little longer so that you can maintain your contributions and tax relief and add to your retirement fund while investment costs are cheap.
‘Although it may be tempting to take as much as possible from the pension at retirement age, evaluate whether postponing and possibly adding to the pot could result in a better situation in the future.
‘Investing over the long term – five or more years – is usually a decent method to weather market downturns, but there are no guarantees.
Although you should avoid making unnecessary changes to your pension, it is vital to review your investments and ensure that you have the appropriate degree of risk based on your goals and expected timeframes for drawing on the pension.
While asset prices are low, retirees who must withdraw income from their pensions while remaining invested should do it as sparingly as possible.
Morgan also observes that market instability has provided a silver lining’ for people seeking to purchase an annuity, as the recent decline in bond prices and rise in yields have been advantageous.
The available revenue has reached its greatest level in almost a decade. Annuities are not appropriate for everyone because you lose access to your money in return for a fixed income, but with average rates a third higher than they were at the beginning of the year, they may be worth considering.
Coles states, ‘If someone was planning to purchase an annuity, they may be naturally frightened by a significant drop in value, but their income has held up quite well. As these “old style” de-risking policies declined, annuity rates increased.
She notes that at the beginning of this year, £100,000 would have provided a 65-year-old with a non-inflation-indexed annual income of £4,950 or a 4.95 percent annuity rate. Today, it would yield a salary of approximately £7,190, or 7.19 percent.
The good news is that you won’t need all of the money on day one, so you may leave it invested and allow it to grow over the decades of your retirement.
However, you will need to reevaluate your investing strategy to determine the optimal asset allocation for your circumstances.
