THE headlong rush of British pension funds into already overpriced long-dated gilts was likened yesterday to trying to squeeze an elephant into a Mini.

Tim Bond, author of the highly regarded Barclays Capital Equity Gilt Study, said that the crisis would slow economic growth, produce smaller annuities for pensioners and lead to a severe misallocation of capital.

Final-salary pension funds in the UK are currently worth £800 billion, while the total supply of long-dated index-linked gilts — the asset class that pension funds were suddenly desperate to buy — is worth just £41 billion.

“This is like trying to squeeze an £800 billion elephant into a £41 billion Mini,” Mr Bond said.

Pension funds’ appetite for long bonds, both index-linked and ordinary, has sent prices soaring and yields plunging to record lows in recent weeks.

“This is a bubble,” Mr Bond said, likening it to the technology boom of 1998-2000, when index-tracking investors had to keep on buying technology shares every time their prices increased in what became a vicious circle.

This time the vicious circle was caused by pension funds bidding up bond prices, which depressed yields. Because these are used to discount pension fund liabilities back to the present day, the effect has been to widen deficits, which in turn leads to funds buying yet more bonds.

The market for long bonds was simply too small to accommodate a wholesale switch by British pension funds into liability matching investments, Mr Bond said.

Long bond real yields have collapsed from a long-run average of 3 per cent to less than 1 per cent. At one moment last month they lurched to less than 0.5 per cent.

Sponsoring companies were in effect paying twice as much as the long-run price for these bonds, Barclays said, leaving less capital available for capital investment. That would feed through into slower economic growth in Britain.

“The gilt bubble is prompting a severe misallocation of capital and, in so doing, is lowering the long-run pace of economic growth,” Barclays said.

Lower bond yields would also lead to lower pensions for people in defined contribution schemes, whose assets have to be used to buy an annuity upon retirement. Annuity rates are largely determined by long bond yields.

Barclays called for a more flexible regime for pension funds rather than the one-size-fits-all policy of using the corporate long-bond rate to discount liabilities.

The study, now in its 51st edition, again reinforces the notion that dividend reinvestment is the key to successful investment: £100 invested in the stock market in 1899 without reinvesting dividends had grown to £11,764 by 2005, a return after adjusting for inflation of just 97 per cent. By contrast £100 invested with dividends reinvested had grown to £1.34 million, a 22,326 per cent real return.

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