UK Pensions Got Margin Calls

Here is a simple model of a pension fund. You know you will need to pay out a bunch of money 30 years from now, so you buy some 30-year government bonds and hold them to maturity. When the bonds mature in 30 years, you have money, which you give to the pensioners, and you’re done. This model is obviously oversimplified,1 but it’s a good start.

Let me make three points about this model. First, a financial point: Doing a pension fund this way is expensive. Thirty-year UK gilts (government bonds) paid about 2.5% interest this summer. If you want to have £100 in 30 years, and bonds pay 2.5%, you’ll need to put aside about £48 now, which will grow at 2.5% over 30 years into £100.2 If you are a company or government, you might not be jazzed about putting aside almost half the money now to pay pension obligations in 30 years. What if you bought some stocks instead? If stocks return 8% a year on average, you can put aside just £10 now to get back £100 in 30 years. That’s a much better deal, for you, now. Of course the gilts pay 2.5% guaranteed, while the 8% stock-market return is just a guess; in 30 years, you (and your pension beneficiaries) might regret your riskier choice. But it saves you money now, and it’ll probably work out fine. Or, you know, you do some mix of super-safe gilts and riskier corporate bonds and stocks, etc., still targeting £100 in 30 years but putting less money in now and taking more risk to get there.