What are gilts and how do they affect pensions?

Pension companies invest pension savings into an investment type called gilts, which offer interest over time – so how does the performance of gilts affect pensions?

What are gilts and how do they affect pensions?

Gilts are a type of asset that pension companies invest savers’ money into. To understand gilts, we need to start with bonds. Bonds are a promise by a borrower to repay a lender their money plus interest on a loan. Gilts are bonds issued by a government. The original paper certificates issued by the UK government were gilt edged – coated in gold leaf.

Gilts are issued by governments when they want to raise money. The length of these loans ranges from just a few months to decades, and the interest paid over a bond’s lifetime is known as a yield, or coupon. Your original investment is back at the end.

Are gilts a safe investment?

To answer this question you need to consider other types of investments, and risk, which is the chance of your investment returning less than you expected. Bonds are thought to be less risky than other investments like property and equities (company shares), but riskier than investing in cash.

The yields from these investments track this risk: if you’re willing to invest in equities, the potential returns are higher than the same amount of money invested in gilts. Gilts are the ‘safest’ type of bond and the UK government has never defaulted on one. But in September 2022, things changed.

What happened to the gilts market in 2022?

The UK government announced tax cuts in a September 2022 ‘mini budget’, without saying how it would pay for them. Tax cuts like these need to be funded through government borrowing, and investors who trade gilts were worried about the government’s ability to pay this debt back.

So lots of gilts were sold, and their values plunged. This meant that yields increased, because the interest payments on them are fixed. So when a £1000 bond dropped in value to £800, the fixed interest payment of £50 changed from a 5% yield to a 6.25% yield.

How did the change in gilts value affect pensions?

As the price of gilts bombed, defined benefit pension schemes, which pay out a proportion of a person’s final salary at retirement, were suddenly in trouble as they often own lots of gilts. These schemes needed to sell gilts fast to fund payments to scheme members, but demand had dried up. Their ability to pay members their guaranteed income was under threat.

Defined contribution schemes pay a retirement income based on the investment performance of money paid in, and invest less in gilts, so were less affected. But members close to retirement may have had their savings switched into gilts.

Pension scheme members were at risk of seeing see their current or previous employer go bust. But the schemes themselves are protected: the Pension Protection Fund pays 100% of a pension owed to insolvent defined benefit scheme members. Those not at retirement age at the point of insolvency get 90% of their pension. And those in defined contribution schemes are protected by the Financial Conduct Authority, who provide compensation to those whose providers are in trouble.

What did the Bank of England do?

The Bank of England said it would buy gilts “on whatever scale is necessary” to restore some order: up to £5bn worth each day for a fixed period. Investors and banks were given a daily time window to offer their gilts for sale to the central bank, who then considered each offer.

The theory was that the gilts price would increase, pushing down yields and protecting pension companies. 30-year government bond yields then dropped overnight by more than 1%, a change that would take months under normal market conditions.

What’s the outlook for UK gilts?

Some uncertainty has set in around gilts – the government’s ‘mini budget’ caused gilt yields to become more volatile than in the past. And although they’re still considered a relatively ‘safe’ investment, a safer assumption is that those yields aren’t quite as ‘gilt edged’ as they once were.

SOURCES

How market shocks affect your pension and whether you should be worried The Times money mentor

What has the Bank done and is my pension safe? The Guardian

What Are Gilts – And How To Invest In Them Forbes

Gilt-Edged Securities Investopedia