Tax cuts torn up and bond market blow-up: Trussonomics revisited

A year ago Liz Truss and Kwasi Kwarteng embarked on a mission to set the UK economy rocketing with a promise of ‘growth, growth, growth’ fuelled by tax cuts. The aborted mission quickly crashed back down to earth, to be superseded by Jeremy Hunt and Rishi Sunak’s plans instead.

The sorry saga shocked markets, triggering a sharp rise in interest rate expectations – and therefore mortgage rates – as well as prompting turmoil in bond markets and leaving taxpayers in a spin trying to work out exactly what the Treasury would be asking them for in future.

DC pensions

Last year’s bond market turmoil caused plenty of angst, but in reality most people with a defined contribution (DC) pension need not have panicked.

A DC pension is invested in funds, shares and bonds, and should be diversified across a range of assets in different countries around the world, meaning any short-term uncertainty in the UK has a limited long-term impact on retirement prospects anyway.

The one group of people in DC pensions who did really suffer were those in annuity hedging strategies, which use ‘lifestyling’ to move into bonds as a chosen retirement date is approaching.

In reality, the liquidity issues linked to the government bond sell-off last year were all about the risks posed by a specific type of hedging strategy operated by ‘defined benefit’ pension schemes, and it is employers that bear the brunt of funding those schemes, not the individual pension saver.

Liability Driven Investments and the bond sell-off

Pensions were dragged into the headlines courtesy of a popular hedging strategy used by DB schemes called Liability Driven Investing, or ‘LDI’. These aim to effectively cancel out the impact gilt yields have on the accounting value of liabilities.

In simple terms, when gilt yields go up and the value of liabilities consequently goes down, the pension scheme is required to pay money to the investment bank running the hedge. If gilt yields went down and liabilities went up, the scheme would receive money from the hedge.

Where yields move quickly – as they did last year at rapid pace – the hedges demand extra cash which, in turn, could force pension funds to sell-off more gilts, potentially creating a dangerous death spiral. When the Bank of England intervened last year that understandably caused concern and reminded some of the dark days of the financial crisis. Although another way to look at this is that the UK’s financial institutions were able to step in to address a specific issue in a targeted fashion, limiting any fallout.

While the headlines made people understandably nervous, ructions in bond markets were no reason to believe there was a threat to the solvency of employer sponsors, which is the key issue for DB pension holders – provided the sponsoring employer stays in business, members should always receive the pension promised. Indeed, a year on DB pension holders remain the envy of many of their peers, and schemes are paying incomes to their members as normal.

Income tax and dividends

Remarkably, by the middle of October 2022 Liz Truss and Kwasi Kwarteng’s headline-grabbing pledge to cut income tax had fallen by the wayside. By the time Jeremy Hunt delivered November’s Autumn Statement, taxpayers were pulling out their calculators and confronting a menu of tax hikes instead of the cuts announced less than two months before.

It was originally planned that a cut to the basic rate of tax to 19% would be introduced, taking £174 off the tax bill on a £30,000 salary. That was swiftly binned by Jeremy Hunt, who announced on the 17^th of October that ‘the Prime Minister and I agreed yesterday to reverse almost all the tax measures announced in the Growth Plan three weeks ago’.

That statement is still as astonishing now as it was then, with Liz Truss’ tax-cutting agenda being ripped to shreds within a month in an effort to calm markets and restore a sense of stability.

Then in November, with new prime minister Rishi Sunak alongside Jeremy Hunt, income taxation was instead increased via the backdoor. While headline rates remained the same – a Conservative party promise at the last election – frozen thresholds mean people are handing more to the taxman as their wages rise. Pay has since increased significantly as companies bid to try and retain staff looking for a raise to match inflation, resulting in a windfall for the Treasury.

Instead of cutting income tax, Jeremy Hunt eventually opted to freeze the basic and higher rate thresholds, and even cut the additional rate threshold for 45% income tax to £125,140.

Investors and company owners also witnessed a rapid change in the tax treatment of dividends. It was originally announced by the Truss-Kwarteng government that the top rate of dividend taxation would be abolished. However, Hunt scrapped that plan, opting instead to cut the dividend allowance dramatically, with the tax-free allowance set to fall to just £500 from April next year.

The change will drag millions of small shareholders into dividend taxation, with an FOI request submitted by AJ Bell finding that an estimated 1.8 million more people will be paying tax on dividends in 2023 and 2024.