The stupid economic policy that toppled UK Prime Minister Liz Truss a mere 44 days into her foray into history is not necessarily a one-off affair. Something like it could happen here or almost anywhere. Since it involves pension plans, maybe a short primer on what she did and how it led to the debacle playing out would be useful. These are the kinds of foreseeable but unintended consequences that can happen when people in charge are not paying attention.
About two-thirds of pension assets in Canada are managed by the eight largest public pension funds — the Canada Pension Plan Investment Board (CPPIB), Caisse de dépôt et placement du Québec (CDPQ) among them. With net investment assets in the $1 – 2 trillion range, the Big Eight are among the world’s largest pension funds. Millions of us get either CPP or QPP. And over 4 million Canadians are covered by defined benefit (DB) pension plans — they’re the employer plans that guarantee retirees a fixed payout regardless of swings in the financial markets — think Air Canada or Enbridge, or the public service.
Most pension plans have lots of bonds (the assets) that pay interest regularly so the plans have income when they need to pay out a retiree’s pension (the liability). No pension fund can achieve a consistent 4-5 per cent real return in the long run without assuming a certain amount of well-diversified risk. So they use “financial instruments” to help keep their assets and liabilities balanced. They’ll arrange to hold some kind of “paper” that will gain value when interest rates go down and lose value when they rise. If the paper loses value because interest rates are going up, the pension fund has to “cover” the loss by selling some of the bonds it holds. The long stretch of low interest rates for the past decade or more made this strategy seem safe.
Then Mrs. Truss announced a cockamamie plan to borrow vast sums of money to reduce taxes. Governments borrow money by selling bonds. It works just like any product that gets dumped on the market: dump a million dozen of eggs onto the market, the price of eggs will drop like a stone. As soon as she announced it, the price of UK bonds started dropping – the very assets held by the pension funds. As their value fell, the pension funds were being called to cover their losses. The only way they could do that was to sell their own bonds, which made the price go down more. A vicious cycle which would have crashed the whole system if the Bank of England hadn’t intervened to buy as many bonds as necessary to stabilize prices.
Here at home, Canadian pension plans use the same kinds of strategies to bolster their returns – they are formally called “liability-driven investment strategies (LDI)”. They are not used to the same extent here, but we should remember that defined benefit plans are allowed to operate when they are underfunded – that means that the present value of all current obligations to pay pensions to members is bigger than the plan’s assets. Most underfunded plans are required to file actuarial reports annually to the Office of the Superintendent of Financial Institutions (OSFI). If a company goes bankrupt and cannot fund its plan, members and retirees may receive less than 100 per cent of their promised pension. (Nortel Networks filed for bankruptcy protection in 2009; 20,000 former employees have been waiting to see if they get their full promised payout.)
I would imagine that the UK experience would prompt Canadian plan sponsors to review their investments and conduct some additional stress tests to account for the fact that financial markets are not particularly upbeat or predictable to-day. I may sound a little paranoid, but I like to be more safe than sorry.
Dian Cohen, C.M., O.M., economist