Investing for DB pension schemes

[Dod101]

Well I said that 'any sensible set of pension trustees will try to hedge any risk to capital values of the bond'. I was trying to introduce the idea of hedging, but I may not have expressed myself very well.

Put it another way. What were or are pension funds hedging themselves against?

Dod

[swill453]

“Senior government source” quoted in today’s Times: “Nobody understands gilts, nobody understands the bond markets unless you’re in it. Certainly no MPs do. We are not running a hedge fund, we are running a government. We are thinking about the long term.”

https://twitter.com/lewis_goodall/statu ... 6911795200

Scott.

[XFool]

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.

This can't quite be right, at least for DB pension schemes, as they don't "pay out pensions in the form of annuities".

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.

Seems surprising in such a low interest rate environment. Surely the obvious risk would be that of an increase?

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.

So were the risks more in the nature of accounting rules risks rather than reality-based risks?

[XFool]

“Senior government source” quoted in today’s Times: “Nobody understands gilts, nobody understands the bond markets unless you’re in it. Certainly no MPs do. We are not running a hedge fund, we are running a government. We are thinking about the long term.”

https://twitter.com/lewis_goodall/statu ... 6911795200

All the more reason to employ/listen to people who have relevant experience and understanding, I would have thought. Rather than ignore or sack them.

[Alaric]

This can't quite be right, at east for DB pension schemes, as they don't "pay out pensions in the form of annuities".

The term pension has acquired two meanings over time. One is a lifetime income as in "State Pension". The other is the funds set aside under pensions legislation such as SIPPs. I was using the former meaning with the term annuity used loosely to mean a lifetime guaranteed income regardless of how it's paid for.

[dealtn]

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

Let me try - although it will be hard. Pension is a two syllable word for a start!

Pension funds consist of an obligation to pay a lot of people over a long period of time. They are liabilities to the fund. Funds therefore need assets to offset these.

In the past it was accepted wisdom that these long liabilities could be met by owning long dated assets such as equities (and properties). Things that last a long time, and typically (due to their risky nature) have a relatively large return on that investment (given the long timescale of likely ownership).

Then (when some fat bloke fell off a boat) it was deemed far to risky for (safe) long term investors to hold risky assets such as equities. Instead it was deemed much more sensible (and the right thing to do for the pensioners) they should "match" those liabilities - which were "bond" like - with safe assets such as Gilts. This of course suited the Government too as given the large national debt (increasing nearly every year by the budget deficit) it always needed a large buyer of its Gilt issuance in the market. Many believed, and many said, Pension Funds had to buy bonds not assets etc. (which wasn't actually true) but suited the Government and a huge part of the finance sector.

Anyway, with the massive fall in yields, assisted of course by "forced" buyers, the Gilt market was permanently squeezed and a large inversion of the Gilt curve could be observed for many years. Very few called "bubble". Even fewer castigated the Government for creating such a distortion (imagine if the nasty "banks" had been responsible, what they would be called now!). This distortion was even greater in the Index Linked market where it was obvious to any that were willing to observe, that people were buying (inflation adjusted) £100 assets for prices over £200. Negative real yields were obvious but "safe".

Pension funds were exhorted to continue inflating (sorry) the bubble further, and even to the point where they no longer had the cash to buy assets to further better match their liability profile (the cost of which was getting higher as the bubble inflated). As such an industry "LDI" grew up where derivative alternatives were created and sold. They, being derivatives, didn't (typically) require an up front cash cost (unlike buying a Gilt, say). But what they did have was an obligation to pay the counterparty if the "bet" went awry (and of course benefit in reverse if it went "right"). Not only do you need to pay over the life of the contract, but due to the regulators being concerned about counterparty risks if the contract failed, you also need to pay "margin" as the price in the market moves.

Now the bubble pops. Russia invades Ukraine, or the amount of QE over the last few years finally spooks the Bond (and inflation) markets. All this previously bought Gilts are well offside. As are the LDI contracts. Ironically of course this is probably good for all the pension funds. They have only matched 50-80% of their liabilities. 100% of the liabilities tumble in value, Against which 50-80% of their assets have now tumbled in value too.

BUT there is only an accounting entry gain of the "halving" in value of the liabilities (all those future pension obligations). The LDI contracts however require an immediate margin call (the change in value of all those derivative cashflows over the next 10-50 years). That margin call needs to be made in cash, or near liquid assets (ironically Gilts). So you now have an immediate forced seller in the market for liquidity (not solvency purposes). Ironically the bigger distressed future seller of Gilts, the Government as issuer to fund those future years of larger deficits due to the markets (correct? incorrect?) view that deficits will be larger due to tax cuts and revenue shortfalls, has to step in as emergency buyer to support the market!

Just like the Great Financial Crash of 2007-8 was actually a liquidity issue (though to this day still many (most?) still think it to be a solvency one). (Whatever happened to all those bank assets distressed sold I wonder? Maybe I should check in with those buyers of all those £1 coins sold at 50p again). This is also a liquidity event.

No doubt many wise fools after the event will decry all those silly enough to enter LDI contracts. The same people will no doubt also attack the banks on the other side for writing them, and the regulator too for allowing it. But what alternative would they have suggested when for the last 20 years the Government, and regulator were "forcing" pension funds to buy expensive assets and inflating the bubble that popped? The reality being Companies (and their Pension schemes) didn't have cash to buy expensive Gilts to 100% hedge their liabilities. Perhaps they should have forced them to sell all equities to "find" that cash - what would have happened to the stock market and pension funds then? Perhaps all companies with pension funds should have been barred from paying dividends (that was seriously suggested). How would that have gone down in the stock market, and with investors on this site (and one Board in particular) do we think?

This is a mania like many preceding it. History doesn't judge kindly those buying tulips centuries ago. For far too long in the industry (and on this site) we have had people saying Bonds are safe, far less volatile than equities, immune to large market moves etc. Maybe the reality of the last couple of weeks will begin to dilute that view.

[monabri]

Slightly off topic ( but what's new?)...I received a pamphlet last week asking for volunteers to become a pension trustee. No pay, reasonable travel expenses, a requirement for a minimum of 4 meetings per year, prep in your own time, and the possibility of being personally held responsible if things go wrong! I think I'll pass!

[EverybodyKnows]

“Senior government source” quoted in today’s Times: “Nobody understands gilts, nobody understands the bond markets unless you’re in it. Certainly no MPs do. We are not running a hedge fund, we are running a government. We are thinking about the long term.”

https://twitter.com/lewis_goodall/statu ... 6911795200

All the more reason to employ/listen to people who have relevant experience and understanding, I would have thought. Rather than ignore or sack them.

The scheme will have professional financial advisers. While the decisions rest with the trustees I would be surprised if trustees ignored that advice on a whim. We always received options, implications and a recommendation. It might be duff trustees or financial advisers or a combination.

[XFool]

“Senior government source” quoted in today’s Times: “Nobody understands gilts, nobody understands the bond markets unless you’re in it. Certainly no MPs do. We are not running a hedge fund, we are running a government. We are thinking about the long term.”

https://twitter.com/lewis_goodall/statu ... 6911795200

All the more reason to employ/listen to people who have relevant experience and understanding, I would have thought. Rather than ignore or sack them.

The scheme will have professional financial advisers. While the decisions rest with the trustees I would be surprised if trustees ignored that advice on a whim. We always received options, implications and a recommendation. It might be duff trustees or financial advisers or a combination.

I was referring to our government.

[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

Let me try - although it will be hard. Pension is a two syllable word for a start!

Pension funds consist of an obligation to pay a lot of people over a long period of time. They are liabilities to the fund. Funds therefore need assets to offset these.

In the past it was accepted wisdom that these long liabilities could be met by owning long dated assets such as equities (and properties). Things that last a long time, and typically (due to their risky nature) have a relatively large return on that investment (given the long timescale of likely ownership).

Then (when some fat bloke fell off a boat) it was deemed far to risky for (safe) long term investors to hold risky assets such as equities. Instead it was deemed much more sensible (and the right thing to do for the pensioners) they should "match" those liabilities - which were "bond" like - with safe assets such as Gilts. This of course suited the Government too as given the large national debt (increasing nearly every year by the budget deficit) it always needed a large buyer of its Gilt issuance in the market. Many believed, and many said, Pension Funds had to buy bonds not assets etc. (which wasn't actually true) but suited the Government and a huge part of the finance sector.

Anyway, with the massive fall in yields, assisted of course by "forced" buyers, the Gilt market was permanently squeezed and a large inversion of the Gilt curve could be observed for many years. Very few called "bubble". Even fewer castigated the Government for creating such a distortion (imagine if the nasty "banks" had been responsible, what they would be called now!). This distortion was even greater in the Index Linked market where it was obvious to any that were willing to observe, that people were buying (inflation adjusted) £100 assets for prices over £200. Negative real yields were obvious but "safe".

Pension funds were exhorted to continue inflating (sorry) the bubble further, and even to the point where they no longer had the cash to buy assets to further better match their liability profile (the cost of which was getting higher as the bubble inflated). As such an industry "LDI" grew up where derivative alternatives were created and sold. They, being derivatives, didn't (typically) require an up front cash cost (unlike buying a Gilt, say). But what they did have was an obligation to pay the counterparty if the "bet" went awry (and of course benefit in reverse if it went "right"). Not only do you need to pay over the life of the contract, but due to the regulators being concerned about counterparty risks if the contract failed, you also need to pay "margin" as the price in the market moves.

Now the bubble pops. Russia invades Ukraine, or the amount of QE over the last few years finally spooks the Bond (and inflation) markets. All this previously bought Gilts are well offside. As are the LDI contracts. Ironically of course this is probably good for all the pension funds. They have only matched 50-80% of their liabilities. 100% of the liabilities tumble in value, Against which 50-80% of their assets have now tumbled in value too.

BUT there is only an accounting entry gain of the "halving" in value of the liabilities (all those future pension obligations). The LDI contracts however require an immediate margin call (the change in value of all those derivative cashflows over the next 10-50 years). That margin call needs to be made in cash, or near liquid assets (ironically Gilts). So you now have an immediate forced seller in the market for liquidity (not solvency purposes). Ironically the bigger distressed future seller of Gilts, the Government as issuer to fund those future years of larger deficits due to the markets (correct? incorrect?) view that deficits will be larger due to tax cuts and revenue shortfalls, has to step in as emergency buyer to support the market!

Just like the Great Financial Crash of 2007-8 was actually a liquidity issue (though to this day still many (most?) still think it to be a solvency one). (Whatever happened to all those bank assets distressed sold I wonder? Maybe I should check in with those buyers of all those £1 coins sold at 50p again). This is also a liquidity event.

No doubt many wise fools after the event will decry all those silly enough to enter LDI contracts. The same people will no doubt also attack the banks on the other side for writing them, and the regulator too for allowing it. But what alternative would they have suggested when for the last 20 years the Government, and regulator were "forcing" pension funds to buy expensive assets and inflating the bubble that popped? The reality being Companies (and their Pension schemes) didn't have cash to buy expensive Gilts to 100% hedge their liabilities. Perhaps they should have forced them to sell all equities to "find" that cash - what would have happened to the stock market and pension funds then? Perhaps all companies with pension funds should have been barred from paying dividends (that was seriously suggested). How would that have gone down in the stock market, and with investors on this site (and one Board in particular) do we think?

This is a mania like many preceding it. History doesn't judge kindly those buying tulips centuries ago. For far too long in the industry (and on this site) we have had people saying Bonds are safe, far less volatile than equities, immune to large market moves etc. Maybe the reality of the last couple of weeks will begin to dilute that view.

Many thanks for that explanation. It is very helpful and makes sense to me. I will read it all again tomorrow and put it together with all the other stuff I have been reading.

Dod

[XFool]

Um...

I don't feel confident I have the whole story here. This thread is entitled "Investing for DB pension schemes" and yet most comments simply refer to "pension funds", which could be DB, DC or a mixture. These are not the same.

To take a real-world, one-off example, my pension is one of them thar "gold plated, indexed, public service(?)" but funded ones. It has UK Fixed Interest at 6.7% of total assets. It also has 2.5% of Index Linked Securities and 12.7% of Private Equity & Private Debt.

So, UK Fixed Interest totals 6.7% of assets. Of course, we don't know exactly what those Index Linked Securities (2.5%) and Private Debt are, but could this have been blown up by recent events?

I think all this may rather depend far more on the type of pension fund and also its funding level (as implied by that FT article).

[Alaric]

I don't feel confident I have the whole story here. This thread is entitled "Investing for DB pension schemes" and yet most comments simply refer to "pension funds", which could be DB, DC or a mixture. These are not the same.

To take a real-world, one-off example, my pension is one of them thar "gold plated, indexed, public service(?)" but funded ones. It has UK Fixed Interest at 6.7% of total assets. It also has 2.5% of Index Linked Securities and 12.7% of Private Equity & Private Debt.

It really doesn't matter what investments are held by DC schemes or DC components of schemes. That's because regardless of whether the investments do well or badly, there's no liability on the sponsoring employer provided there aren't guarantees.

It's interesting that a public sector funded scheme remains in equities. That may well be because it doesn't have the same reporting requirements as private sector schemes where market value fluctuations in assets, particularly equities, show up on the sponsoring Company's balance sheet and income statements.

I think the story is that some DB pension schemes were in effect borrowing to invest. The way they took out the "loan" was such that they were vulnerable to cash flow problems if there was a sudden rise in yields on Government Bonds. The BoE had to step in to reverse the yield change. Accounting rules are at least in part to blame by making investment in equities more difficult to justify.

[Dod101]

Um...

I don't feel confident I have the whole story here. This thread is entitled "Investing for DB pension schemes" and yet most comments simply refer to "pension funds", which could be DB, DC or a mixture. These are not the same.

To take a real-world, one-off example, my pension is one of them thar "gold plated, indexed, public service(?)" but funded ones. It has UK Fixed Interest at 6.7% of total assets. It also has 2.5% of Index Linked Securities and 12.7% of Private Equity & Private Debt.

So, UK Fixed Interest totals 6.7% of assets. Of course, we don't know exactly what those Index Linked Securities (2.5%) and Private Debt are, but could this have been blown up by recent events?

I think all this may rather depend far more on the type of pension fund and also its funding level (as implied by that FT article).

A public service funded pension scheme is surely one of those 'indefinite intergenerational savings vehicles' referred to in the original article. It will usually have much higher equity content than those schemes closed to new members, (which is the main subject of the discussion and where the crisis has arisen) and a much lower holding of any form of fixed interest. I do not know a lot about DC schemes, but since they have no guarantee, all the investment risk is borne by the individual (which of course is how they were designed)

It does indeed depend on the type of scheme.

Dod

[Dod101]

I don't feel confident I have the whole story here. This thread is entitled "Investing for DB pension schemes" and yet most comments simply refer to "pension funds", which could be DB, DC or a mixture. These are not the same.

To take a real-world, one-off example, my pension is one of them thar "gold plated, indexed, public service(?)" but funded ones. It has UK Fixed Interest at 6.7% of total assets. It also has 2.5% of Index Linked Securities and 12.7% of Private Equity & Private Debt.

It really doesn't matter what investments are held by DC schemes or DC components of schemes. That's because regardless of whether the investments do well or badly, there's no liability on the sponsoring employer provided there aren't guarantees.

It's interesting that a public sector funded scheme remains in equities. That may well be because it doesn't have the same reporting requirements as private sector schemes where market value fluctuations in assets, particularly equities, show up on the sponsoring Company's balance sheet and income statements.

I think the story is that some DB pension schemes were in effect borrowing to invest. The way they took out the "loan" was such that they were vulnerable to cash flow problems if there was a sudden rise in yields on Government Bonds. The BoE had to step in to reverse the yield change. Accounting rules are at least in part to blame by making investment in equities more difficult to justify.

But ongoing public sector funded DB schemes remain the 'indefinite intergenerational savings vehicle' referred to in the original article. These have for a long while been invested in equities as they were seen as providing better returns and providing some protection against inflation. These long term schemes could also stand the ups and downs of the returns seen from equites. They sometimes became over funded and sometimes the opposite but it did not matter as they had an indefinite life.

Traditionally (that is 'way back), DB pension schemes used mostly gilts and other forms of fixed interest as they were considered low risk and meeting the requirements of their liabilities (see LDI today) but that was before the days of elaborate derivatives (They were mainly confined to farmers selling their crop for a fixed price, in the spring) so that there was little or no risk of a blow up like this last week. Then, partly when inflation began to affect the returns and equities were giving a much better return, they turned to equites and the 'cult of the equity' was born sometime post Second World War. Once DB schemes began to close to new members because of the cost to the sponsoring company in periods of sustained high inflation, and much closer attention was being paid to their year on year valuations, the investment profile had to change and they began a shift towards gilts, but this time accompanied by these 'weapons of financial destruction', derivatives.

That is as I see it anyway.

[XFool]

But ongoing public sector funded DB schemes remain the 'indefinite intergenerational savings vehicle' referred to in the original article.

Could you please give a link to, or at least the name of, the original FT article you are referring to. You did not include it in the OP and I would like to see what it says about DB pensions and whether it is directly related to recent events.

Thanks.


BTW. I see the server behind my original link to a copy of the FT article on LDI is down today. So here is an alternative:

LDI: the better mousetrap that almost broke the UK

https://todayuknews.com/market/ldi-the-better-mousetrap-that-almost-broke-the-uk/

[Dod101]

But ongoing public sector funded DB schemes remain the 'indefinite intergenerational savings vehicle' referred to in the original article.

Could you please give a link to, or at least the name of, the original FT article you are referring to. You did not include it in the OP and I would like to see what it says about DB pensions and whether it is directly related to recent events.

Thanks.


BTW. I see the server behind my original link to a copy of the FT article on LDI is down today. So here is an alternative:

LDI: the better mousetrap that almost broke the UK

https://todayuknews.com/market/ldi-the-better-mousetrap-that-almost-broke-the-uk/

The original article was in the FT yesterday headed

'UK pension fund crisis shows there is no capitalism without capital or risk', written by Michael Tory.

I do not have a link to it. Sorry.

Dod

[XFool]

Thanks Dod.

Unfortunately, the only available non FT version I can readily find appears to have been auto-translated (badly) from a foreign language and requires retranslation into English English.

The article is also shown to be on that World News server, which is currently down.

[Alaric]

The article is also shown to be on that World News server, which is currently down.

The usual trick of a Google search for the headline is working.

The article traces the roots of the crisis back twenty five years when regulatory and taxation restrictions on defined benefit schemes got such that employers no longer felt able to keep them open.

[XFool]

The article is also shown to be on that World News server, which is currently down.

The usual trick of a Google search for the headline is working.

Yes of course! Why didn't I think of that? I am using Edge on my laptop currently, so the in-browser search is always Bing. I should know better as I am used to going to Google if I think Bing isn't up to the job.

UK Pension Fund Disaster Exhibits There Is No Such Thing As A Capitalism With Out Capital Or Threat

https://www.newsncr.com/business/uk-pension-fund-crisis-shows-there-is-no-capitalism-without-capital-or-risk/

Hang on... No. That is another Manglish version. Is there anything better than this? Or just have to translate it to English?

Manglish:
It is past ironic that an funding technique that claimed to remove danger threatened the unprecedented failure of the UK pension system this week.

English:
It is beyond ironic that a funding technique(?) that claimed to remove risk threatened the unprecedented failure of the UK pension system this week.

etc.

[XFool]

Meanwhile, there is this. Which seems to confirm much of the above and does indeed relate it to DB pensions:

The Pension Problem That Threatened to Wreck the Gilt Market

https://www.bloomberg.com/news/articles/2022-09-28/the-uk-pension-problem-that-threatened-to-wreck-the-gilt-market

The Bank of England intervened in the gilt market on Wednesday
BOE was concerned that margin calls would cause a gilt crash

"The size of the LDI market has exploded over the past decade. The amount of liabilities held by UK pension funds that have been hedged with LDI strategies has tripled in size to £1.5 trillion in the 10 years through 2020, according to the Investment Association. These trades are typically used by defined benefit pension schemes."

So, it is related to DB pensions because of the defined benefits; to keep fund volatility off the sponsoring company's 'books' - ironically; possibly used more by underfunded pension funds - using equities to try to 'catch up' ?