Market News

But try as they might to soothe investors, epochal shifts in the pensions industry mean the next prime minister may face an almighty financial reckoning nonetheless.

The reason? One of the biggest buyers of government debt is about to become a seller – pushing up state borrowing costs as a result.

Defined benefit pension schemes, often known as final salary pensions, have traditionally been big buyers of the Government’s long-term debt.

The Treasury could keep borrowing cheaply as these pension funds were effectively guaranteed lenders through the gilt market.

But most of those schemes have closed to new contributions. Employers have shifted from costly defined benefit schemes to defined contribution pensions, which link payouts to the amount workers save rather than their final salaries.

Now, the sun is setting on the defined benefit industry as members reach retirement age.

As a result, instead of buying bonds, these funds are going to ditch around £40bn of long-dated gilts over the next five years as they raise funds to pay out to pensioners.

“Defined benefit pensions have been, for well over two decades, reliable investors in UK government debt,” says Francisco Sebastian, an analyst at Uncompromised Research and the author of a National Institute of Economic and Social Research (NIESR) report on the issue.

“They have historically been that anchor investor providing that capital, especially for very long-term debt. Now that is changing.”

The need for buyers of government debt is only growing: whoever wins the election is likely to keep borrowing very heavily.

This financial year, the budget deficit will come in at more than £120bn, according to the Office for Budget Responsibility (OBR). Next year it will be almost £85bn, then £76bn the year after. That is a collective £281bn the Government will likely have to borrow in just three years.

In this context, an extra £40bn of gilts being sold into the market by defined benefit schemes will be significant.

“If we look at the amount of debt the Government has to issue, [£40bn] is a very large amount – well in the double digits as a percentage,” Sebastian says. “And if we look at the proportion relative to the amount of long-term debt, it is also a very large number.

“It means the Government’s safety in terms of issuing very long-term debt, which gives you peace of mind for a few years, is compromised.”

The loss of pension funds as major investors means, all else being equal, higher borrowing costs.

For a taste of things to come, look at the Government’s debt interest bill. Last year, it totalled £116bn, compared to £38bn a decade ago. Last year’s annual total is bigger than this year’s entire £88.7bn budget for the Department of Education. In coming years, the debt interest bill will briefly dip but remain above £100bn for the foreseeable future, the OBR predicts.

The high interest bill is partly a function of the mammoth national debt, which has spiralled to £2.7 trillion, equivalent to 98pc of GDP. But this simply means the Government is far more sensitive to higher borrowing costs.

It is not just pension funds creating a borrowing headache in Westminster. Another key buyer of gilts since the financial crisis has been the Bank of England.

It bought £875bn of government bonds under its quantitative easing programme, pushing down government borrowing costs for more than a decade and leading some people to wrongly conclude that near free money would be available indefinitely.

The Bank and British pension funds “have been able to suppress interest rates for many years,” Sebastian says.

Now, however, the Bank is selling bonds just like the pension funds. It is cutting its holdings by around £100bn a year under quantitative tightening (QT).

The net result is the Government will either have to rein in borrowing or rely more heavily on foreign investors in future years. The latter strategy will not be cheap.

“Foreign investors tend to be more short-term in nature,” Sebastian says. “They are more opportunistic, they are going to look for a good deal.

“If the Government has less access to a pool of capital, it will have to pay up.”

Foreign investors are not tied to UK assets and the Government will be competing with global markets.

“When these investors see an opportunity, they come all at once. And when they see there is no longer an opportunity, they sell up and leave all at the same time,” says Sebastian.

That means more volatility in bond markets, and so in borrowing costs paid by the Government, households and businesses.

It also means more swings in sterling’s value, with big flows of cash in and out of the country.

“The liability driven investment (LDI) crisis of 2022 was partly due to this phenomenon and can serve as a template for future shocks, which may become more frequent,” warns Sebastian. “The underlying problem of a lack of committed investors is still there.

“It is coming at a time when the UK economy is under most pressure from QT from the Bank of England, extreme expenditure from the Government, society asking for more expenditure, the extreme needs for investment that are not being realised – it is coming at the worst time possible.”

Pensions management and bond market dangers are not the classic stuff of election campaign promises and will hardly get voters’ pulses racing on the doorstep. But the public will notice another market meltdown.

Whether it is Sunak or Starmer in No 10 next year, the next prime minister will face an almighty task navigating these waters and putting public finances on firmer footing.

Sebastian says: “There is no quick fix for this.”

A Treasury spokesman said: “Recent gilts sales show there is strong demand and the type of investors is diverse, which ensures we are not overly reliant on just one kind. As always, we listen closely to feedback from the gilt market so our plans are in line with demand.”