Investing for DB pension schemes

[swill453]

As everyone knows, virtually all DB pension schemes are closed to new members and have been for some years.

Is that even a true statement? Aren't there still loads of public sector workers in DB pension schemes*?

And private sector ones aren't completely extinct either, as far as I know.

* - some are unfunded of course, but not all of them.

Scott.

[BullDog]

In my naivety, I thought that a company selling a closed DB pension scheme is usually doing so at least to remove the potential liability of having to fund a shortfall and getting the scheme off its books. I doubt very much that all the schemes that say L & G takes on are not fully secured and funded. To turn your question back on you, why then would L & G buy them? They are taking them on because they hope over the remaining lifetime of the schemes that they can make some money from them by pooling the assets with others and making savings in the costs of admin if nothing else.

Dod

I can obviously only describe the two DB plans I am a member of, both with L&G. Both employer companies continued until quite recently to make considerable contributions to the DB plans until they were more than 100% funded for future liabilities. One of them as recently as last year made almost a 1/4 billion GBP payment into the DB plan. Both plans now report quite a bit over 100% funding in their latest reports. So at least short term, I'd have thought they were now off the hook for further contribution. I would think that all this stuff is negotiated in fine detail between L&G, the DB pension trustees and the employers before a plan is taken on by L&G.

Thanks. I do not have any idea what sort of contract there is between the original company sponsor and say L & G. It seems that if L & G say, is not happy with the funding of the scheme they are buying that further contributions may be required, judging by your comments. I guess that makes sense. I wonder though, if a scheme is actuarially fully funded if such a provision would appear? I would have thought that that would allow the sponsor to be off the hook but I realise that I know very little about this sort of thing.

What you are saying is almost as if L & G are simply replacing the original pension scheme trustees. Interesting.

Dod

No. The trustees are entirely separate and independent of the employer company and the plan managers (L&G). Effectively, the employer company completely outsources the future management of the assets within the DB scheme. They no longer run an in house pensions department. I don't know details of the agreement between L&G and the employer company. It appears to me that if immediate liquidity is required when the derivatives are failing, and it exceeds a certain threshold, then the employer company has to cough up. But it's really beyond my pay grade beyond reading and believing the trustees when they tell me that in excess of plan liabilities are fully funded.

Thanks. You are helping me to tease out how these things work. So at least in your case L & G are as you say, simply the plan managers. I wonder how far there responsibility stretches?

Dod

I can't answer the question really. The fine detail of how this stuff works isn't readily available. If I were inclined I could ask the trustees for more information. But contractual stuff between L&G and the employer just wouldn't be part of the discussion. The trustees represent the members interests and I am guessing after a point, the respnse is "trust us we know what we're doing". I am not sure I can add much more to the conversation.

[Newroad]

What's going on?

To summarise as I understand it

Pension funds have predominantly long-term liabilities

They don't (or didn't) have enough capital to buy long term gilts to match, especially in the previous very low interest rate environment

So they bought assets with a higher expected rate of return over the long term as an alternate means to match their liabilities, e.g. equities

This put them at risk of a mismatch over time between assets and liabilities - e.g. bond prices rise (which itself increases their liabilities, as they are often a/the reference point) but not equities, at least, not as quickly

So, they bought derivatives contracts to cater for the above scenario

Due to the Truss/Kwarteng mini-budget, the opposite scenario occurred - bond prices went the other way

Pandemonium

The above lends heavily on an FT article I read elsewhere.

Regards, Newroad

[EverybodyKnows]

And with my main source of income now two DB pensions which are now effectively group annuities with L&G, I was shocked to discover that there was anything more than slight risk involved in the management of them. I am left wondering if the pension trustees, especially employee lay trustees, really fully understand the part the funny money derivatives are now playing in formerly securely funded final salary pension schemes. In practice, the members entitlement to the pensions we now enjoy is deferred salary. The pension entitlements are paid for during employment. The latest reports from the pension trustees state that these LDI instruments that seem to have almost blown up last week are used in both my DB pension schemes.

Why would your company sell a fully secured and funded final salary pension scheme. More pertinently why would L&G (or others) buy them?

I suspect the former sold to the latter because they weren't as secure and funded as you believe. That's what creates a market for companies like L&G, they accept the risk for a price.

In my naivety, I thought that a company selling a closed DB pension scheme is usually doing so at least to remove the potential liability of having to fund a shortfall and getting the scheme off its books. I doubt very much that all the schemes that say L & G takes on are not fully secured and funded. To turn your question back on you, why then would L & G buy them? They are taking them on because they hope over the remaining lifetime of the schemes that they can make some money from them by pooling the assets with others and making savings in the costs of admin if nothing else.

Dod

I have previously been a Pension Trustee of a DB scheme. I was surprised to learn there were different definitions of 'fully funded'. Trustees care about whether there are sufficient funds to meet current and future needs. Employers care about the 'buy out' cost ie how much is it to transfer all of the liabilities to an insurer. These figures are very different with the latter being much greater than the former as the insurer wants to make a profit and is committing to manage the funds, administer payments for many years and be liable for any past issues (and/or changes in case law).

The main benefit to the employer is reduced risk and to a lesser extent a lower administrative burden (management time, running costs). Having a DB scheme attached to your company makes many things more difficult and time consuming especially if you want to borrow money. For bigger employers this may be easier but small (ish) ones struggle.

[XFool]

I have previously been a Pension Trustee of a DB scheme. I was surprised to learn there were different definitions of 'fully funded'. Trustees care about whether there are sufficient funds to meet current and future needs. Employers care about the 'buy out' cost ie how much is it to transfer all of the liabilities to an insurer. These figures are very different with the latter being much greater than the former as the insurer wants to make a profit and is committing to manage the funds, administer payments for many years and be liable for any past issues (and/or changes in case law).

Certainly - I was a bit surprised that you were surprised by this - isn't it usually reported in the scheme annual reports? As an example from my own DB pension scheme, using figures from the 2019 valuation date:

Ongoing Funding Level 125%
Value for Insurance Buy Out 74%

[Dod101]

As everyone knows, virtually all DB pension schemes are closed to new members and have been for some years.

Is that even a true statement? Aren't there still loads of public sector workers in DB pension schemes*?

And private sector ones aren't completely extinct either, as far as I know.

* - some are unfunded of course, but not all of them.

Scott.

Quite right to challenge that comment but I thought public sector schemes were pretty well all unfunded, and they are just paying benefits 'out of the till'

Private sector DB pensions are pretty well extinct I think. They may not be completely, but close to it.

Dod

[Alaric]

Quite right to challenge that comment but I thought public sector schemes were pretty well all unfunded, and they are just paying benefits 'out of the till'

Local government is funded and so were nationalised industry ones. Most of those were privatised with the sponsoring employers, but perhaps not the miners' scheme.

From the horse's mouth
https://commonslibrary.parliament.uk/re ... /cbp-8478/

The six largest public service pension schemes in the UK – the schemes for the Armed Forces, the Civil Service, NHS, Teachers, Police and Firefighters (which operate on a pay-as-you-go basis) and the Local Government Pension Scheme (which is funded) are statutory defined benefit (DB) pension schemes (i.e. they provide pension benefits based on salary and length of service).

Another big one that is funded is the one for university staff. https://www.uss.co.uk/
https://www.uss.co.uk/how-we-invest/how ... e-invested

[ursaminortaur]

As everyone knows, virtually all DB pension schemes are closed to new members and have been for some years.

Is that even a true statement? Aren't there still loads of public sector workers in DB pension schemes*?

And private sector ones aren't completely extinct either, as far as I know.

* - some are unfunded of course, but not all of them.

Scott.

Quite right to challenge that comment but I thought public sector schemes were pretty well all unfunded, and they are just paying benefits 'out of the till'

Private sector DB pensions are pretty well extinct I think. They may not be completely, but close to it.

Dod

The major funded public sector DB scheme is the local government scheme (LGPS). Though there are other public sector funded DB schemes including the
MP and minister schemes.

https://www.lgpsmember.org/about-the-lgps/about-the-lgps/

The LGPS is one of the largest pension schemes in the UK. It is a defined benefit pension scheme which means your pension is based on your salary and how long you pay into the Scheme.

https://commonslibrary.parliament.uk/research-briefings/sn06283/

The Parliamentary Contributory Pension Fund (PCPF) is made up of the MPs’ Pension Scheme and the Ministers’ Pension Scheme. It is a funded defined benefit (DB) pension scheme, managed by Trustees in line with scheme rules and any relevant legislation.

[scotview]

For me there are a few questions remaining.

1 I'm still not clear on just how close, in reality, the DB pension system was to collapse. £65 billion in immediate support isn't an insignificant number though.

2 What will happen after the BoE's buying exercise finishes in October, will volatility return ?

3 Will these DB "admin/insurance companies" have to go back the funding companie's for more cash? I'm sure the funding company boards will be going apoplectic.

4 Could there be a "mis-selling" review instigated which could take most of these insurance companies under.

5 The closure of DB and migration to DC schemes seems now to be a master stroke.

6 Surely this is the death knell for unfunded, index linked Public Sector pensions.

[ursaminortaur]

Quite right to challenge that comment but I thought public sector schemes were pretty well all unfunded, and they are just paying benefits 'out of the till'

Local government is funded and so were nationalised industry ones. Most of those were privatised with the sponsoring employers, but perhaps not the miners' scheme.

From the horse's mouth
https://commonslibrary.parliament.uk/re ... /cbp-8478/

The six largest public service pension schemes in the UK – the schemes for the Armed Forces, the Civil Service, NHS, Teachers, Police and Firefighters (which operate on a pay-as-you-go basis) and the Local Government Pension Scheme (which is funded) are statutory defined benefit (DB) pension schemes (i.e. they provide pension benefits based on salary and length of service).

Another big one that is funded is the one for university staff. https://www.uss.co.uk/
https://www.uss.co.uk/how-we-invest/how ... e-invested

But note that the USS is a private rather than public sector scheme

https://www.uss.co.uk/about-us/who-we-are


We're Universities Superannuation Scheme

Established in 1974, we're the largest private pension scheme in the country, and the principle pension scheme for universities and Higher Education institutions in the UK

[Dod101]

As everyone knows, virtually all DB pension schemes are closed to new members and have been for some years.

Is that even a true statement? Aren't there still loads of public sector workers in DB pension schemes*?

And private sector ones aren't completely extinct either, as far as I know.

* - some are unfunded of course, but not all of them.

Scott.

I was actually thinking of private, DB pension schemes when I wrote that. I think that virtually all of those schemes have now been closed to new members.

I readily admit that I had not researched public DB schemes as the whole sector is pretty much a closed book to me.

Dod

[ursaminortaur]

For me there are a few questions remaining.

1 I'm still not clear on just how close, in reality, the DB pension system was to collapse. £65 billion in immediate support isn't an insignificant number though.

2 What will happen after the BoE's buying exercise finishes in October, will volatility return ?

3 Will these DB "admin/insurance companies" have to go back the funding companie's for more cash? I'm sure the funding company boards will be going apoplectic.

4 Could there be a "mis-selling" review instigated which could take most of these insurance companies under.

5 The closure of DB and migration to DC schemes seems now to be a master stroke.

6 Surely this is the death knell for unfunded, index linked Public Sector pensions.

Unfunded public sector pension schemes will not have been affected by this as they are not investing. Switching those unfunded schemes to either funded DB schemes or DC schemes is never going to happen as it would mean that the Government would need to make real employer contributions and could no longer take the employee contributions to use in its spending whilst it would still have to pay out the accrued benefits of members ( both those already retired and those who retired later). This would require the government to spend extra money and hence either raise taxes, increase borrowing or print money.

[Dod101]

For me there are a few questions remaining.

1 I'm still not clear on just how close, in reality, the DB pension system was to collapse. £65 billion in immediate support isn't an insignificant number though.

2 What will happen after the BoE's buying exercise finishes in October, will volatility return ?

3 Will these DB "admin/insurance companies" have to go back the funding companie's for more cash? I'm sure the funding company boards will be going apoplectic.

4 Could there be a "mis-selling" review instigated which could take most of these insurance companies under.

5 The closure of DB and migration to DC schemes seems now to be a master stroke.

6 Surely this is the death knell for unfunded, index linked Public Sector pensions.

Unfunded public sector pension schemes will not have been affected by this as they are not investing. Switching those unfunded schemes to either funded DB schemes or DC schemes is never going to happen as it would mean that the Government would need to make real employer contributions and could no longer take the employee contributions to use in its spending whilst it would still have to pay out the accrued benefits of members ( both those already retired and those who retired later). This would require the government to spend extra money and hence either raise taxes, increase borrowing or print money.

These unfunded public sector 'pension schemes' are not really comparable to what I was writing about. I would argue that they are not pension schemes at all, but rather a set of rules for paying a pension to employees when they reach retirement.

And after all these words, I am still no wiser about what actually caused the problems in this last week. Could someone explain preferably in words of one syllable, why margin calls arose (as they seem to have been the cause of the crisis)?

Dod

[Alaric]

This would require the government to spend extra money and hence either raise taxes, increase borrowing or print money.

Paying out on unfunded public sector pension benefits is a first charge on taxation and other government revenue. So for that matter are coupon and repayments on Government borrowing. I suppose like PFI, running unfunded schemes has the advantage of not putting the borrowing on the PSBR.

The schemes get revenue from employee and employer contributions although in the case of employer contributions it's just another government expense. If they ran funded defined contribution schemes, the contributions would likely leave the public sector.

[XFool]

There was a good Alphaville segment in the FT on LDI.

Not sure if viewable without subscription but search on “LDI the better mousetrap that almost broke the UK”.

Thanks.

https://worldnewsera.com/news/finance/stock-market/ldi-the-better-mousetrap-that-almost-broke-the-uk/

Problems with “pension plumbing” are what caused the mess. The culprit is said to be a popular pension strategy called liability-driven investing, or LDI.

What on earth happened this week?

In short, gilt yields soared. That forced UK pensions to sell gilts. That pushed gilt prices even lower and yields even higher, which forced UK pensions to sell more gilts (and other liquid assets), and so on. The Bank of England intervened to stop the spiral.

But no explanation of WHY they had to sell. I can only assume it is because their price had dropped - therefore they were devalued as 'assets' to match 'liabilities'?

This sounds as if it is as good an idea as 1970s Portfolio Insurance.

What did they need the cash for?

Well, the cruel irony is that pensions needed collateral for margin calls on leveraged trades hedging against big moves in . . . UK government bond yields.
So pensions sold bonds (among other things) to raise that cash, pushing yields up, making hedging trades even more expensive, and requiring even more collateral.

Hang on! This sounds exactly like 1970s Portfolio Insurance. It's 1987 all over again.

In fact, the basic concept of “liability-driven investing,” or LDI, just means planning your investments’ cash payouts to your future cash needs. In a simple world, you wouldn’t need derivatives to do this at all. Pensions would simply buy bonds that would pay out what they need to pay pensioners, when they need to pay pensioners. Need a lump-sum payment in the future? Buy a zero-coupon bond that matures on that date! Easy.

So...

Probably best to just read it all yourself.

[EverybodyKnows]

I have previously been a Pension Trustee of a DB scheme. I was surprised to learn there were different definitions of 'fully funded'. Trustees care about whether there are sufficient funds to meet current and future needs. Employers care about the 'buy out' cost ie how much is it to transfer all of the liabilities to an insurer. These figures are very different with the latter being much greater than the former as the insurer wants to make a profit and is committing to manage the funds, administer payments for many years and be liable for any past issues (and/or changes in case law).

Certainly - I was a bit surprised that you were surprised by this - isn't it usually reported in the scheme annual reports? As an example from my own DB pension scheme, using figures from the 2019 valuation date:

Ongoing Funding Level 125%
Value for Insurance Buy Out 74%

As a (then) new Trustee it was a surprise as I thought "fully funded" would have one definition. I learnt a great deal about the world of pensions doing that work. The Trustee toolkit is a great place to learn more about pension schemes: https://trusteetoolkit.thepensionsregulator.gov.uk/

The "value for insurance buy out" that your scheme refers to must surely be an estimate? Maybe they were in the middle of transacting a deal? Or perhaps the rules have changed?

Certainly in my experience the precise number varied significantly depending on when you transacted and what other deals had been done that year as it was a negotiation with the various potential insurers. It was a small scheme in the world of pensions (circa 400 members) so perhaps for the larger schemes it is easier to calculate.

[Dod101]

I have previously been a Pension Trustee of a DB scheme. I was surprised to learn there were different definitions of 'fully funded'. Trustees care about whether there are sufficient funds to meet current and future needs. Employers care about the 'buy out' cost ie how much is it to transfer all of the liabilities to an insurer. These figures are very different with the latter being much greater than the former as the insurer wants to make a profit and is committing to manage the funds, administer payments for many years and be liable for any past issues (and/or changes in case law).

Certainly - I was a bit surprised that you were surprised by this - isn't it usually reported in the scheme annual reports? As an example from my own DB pension scheme, using figures from the 2019 valuation date:

Ongoing Funding Level 125%
Value for Insurance Buy Out 74%

As a (then) new Trustee it was a surprise as I thought "fully funded" would have one definition. I learnt a great deal about the world of pensions doing that work. The Trustee toolkit is a great place to learn more about pension schemes: https://trusteetoolkit.thepensionsregulator.gov.uk/

The "value for insurance buy out" that your scheme refers to must surely be an estimate? Maybe they were in the middle of transacting a deal? Or perhaps the rules have changed?

Certainly in my experience the precise number varied significantly depending on when you transacted and what other deals had been done that year as it was a negotiation with the various potential insurers. It was a small scheme in the world of pensions (circa 400 members) so perhaps for the larger schemes it is easier to calculate.

Many thanks for this. When I get a spare hour or two I will definitely look at this Toolkit.

Dod

[Dod101]

So the conclusion I come to is that there was a sloppy or negligent attention to potential liabilities on the part of the pension trustees. Furthermore, why should the sponsors of these pension funds not be bailing out the funds themselves? That is I imagine much too simplistic but would seem to me to be the nub of the problems of this week.

Dod

[XFool]

The "value for insurance buy out" that your scheme refers to must surely be an estimate? Maybe they were in the middle of transacting a deal? Or perhaps the rules have changed?

Yes, really it was an actuary's "estimate".

[dealtn]

So I do not understand then what all the fuss was about last week. can you enlighten me please?

The problem seems to have been that these schemes took out derivative contracts which protected them if interest rates fell. Falling interest rates have the side effect that the values placed on the promises to pay out pensions in the form of annuities will increase. That can have an effect on the sponsoring Company's accounts given the way the accounting rules ae written.

It appears they didn't take account of the risk that if interest rates rose sharply, always a possible political risk, that they would be crippled by cash demands on their derivatives.

Funded defined benefit schemes have been around a long time, over a hundred years perhaps. In that time period, Gilt yields have been 4% and I dare say occasionally increased to 5% over a short period. The pension schemes will have serenely sailed through without precipitaing emergency action by the Bank of England or Government. That's until now.

One solution of sorts would be to relax the rules on reporting pension gains or losses. After all if a Company buys another Company for far more than it's worth, that gets covered up as "goodwill". For example you could run a year by year projection of the outgo and a year by year projection of the asset income. if the scheme is in deficit the outgo will exceed the income. You then discount the shortfalls, not at a Gilt rate, but at some rate the Company might use for internal project assessment.

Thanks. It used to amuse (or bemuse?) me the way that pension schemes calculate their liabilities because of course they are only as good as the parameters that an actuary feeds in to the model. It does not take much in a big scheme for a small change in these to cause a very high change in the outcome, so although these valuations are treated with great respect, almost reverence, they are not I think necessarily all that accurate, and yet empires can be lost because of them.

Re your comment about derivatives, what you have said is mor or less what I was trying to say early on in this thread but dealtn more or less dismissed that.

Could an actuary in the house help out?

Dod

No you painted a scenario of a pension fund that was in a hedged state and didn't own any derivatives. If you now want to change the pension fund that has a a large derivative as part of its hedge then you can expect a different response by way of explanation.