Investing for DB pension schemes

[ChrisNix]

[
Wasn't the principle that the fund bought Gilts, I-L or otherwise, with maturities to match their future liabilities? I'm looking here at pensions in payment, not those of active members. Buying and holding to maturity is fine for new issues, but could be disastrous if the gilt to be bought was at a hefty premium.

That was the principle, but there are some practical points. Inceasingly schemes didn't have any active members either because they had all left the Company or because the scheme had left them by closing both to new membership and additional accrual. When that happens you also have bond like liabilities for people with benefits frozen except for indexation, but who won't be taking an income for another ten, twenty years or longer. There aren't howrver indexed zero coupon bonds, even if recent low coupon issues come close, so the available assets are of a shorter term than the liability cash flows. Hence presumably LDis which attempt to allieviate the losses that would otherwise arise when interest rates fall and a reason why a rise in interest rates is good in a slightly longer horizon for a closed scheme.

There's a theorem on valuation of future cash flows which is always worth bearing in mind. It's this, that if you take two sets of cash flows and value them using the same rate of interest, you find that the set of cash flows that on average is further in the future will change values more when interest rates change.

What are the losses which you think arise for schemes when interest rates fall?

Their expected benefit outflows haven't altered.

And if their assets were, previous to fall, expected to generate sufficient cash inflows to cover outflows, the funding equation is also unchanged.

[Alaric]

What are the losses which you think arise for schemes when interest rates fall?

Their expected benefit outflows haven't altered.

And if their assets were, previous to fall, expected to generate sufficient cash inflows to cover outflows, the funding equation is also unchanged.

They are required to mark down the market value of the assets by more than they can mark down the value of the liabilities. It's a phantom loss but accounting rules seem to insist on it. Whilst you can cash flow match a set of liabilities consisting entirely of annuities in payment, when you have deferred liabilities as well, it's difficult to avoid having unmatched cash flows in from coupons until the deferred benefits come into payment.

When they talk of a funding level of 100% they mean the value placed on the flow of liabilities out into the future is the same as the market value of the assets. That's a weaker position than saying every future liability outgo is matched by asset proceeds in each future time period.

[dealtn]

If banks are lent funds by BofE at increasingly low interest rates, they and their hedge fund clients can be expected to gorge on the carry available in bonds, in particular gilts.

What is this mysterious BofE lending regime and the carry trade you are referring to?

[ChrisNix]

What are the losses which you think arise for schemes when interest rates fall?

Their expected benefit outflows haven't altered.

And if their assets were, previous to fall, expected to generate sufficient cash inflows to cover outflows, the funding equation is also unchanged.

They are required to mark down the market value of the assets by more than they can mark down the value of the liabilities. It's a phantom loss but accounting rules seem to insist on it. Whilst you can cash flow match a set of liabilities consisting entirely of annuities in payment, when you have deferred liabilities as well, it's difficult to avoid having unmatched cash flows in from coupons until the deferred benefits come into payment.

When they talk of a funding level of 100% they mean the value placed on the flow of liabilities out into the future is the same as the market value of the assets. That's a weaker position than saying every future liability outgo is matched by asset proceeds in each future time period.

If we're talking likelihood of funding objectives being met, so long as the the expected income remains the same the market value of assets isn't of great concern. Even less so if compared with a faulty estimate of liabilities, which most certainly overestimates the market value.

Phantom loss is a good description, but unfortunately margin calls are real.

Under the scheme specific funding regime, liabilities were meant to be discounted by the prudent level of expected returns on the assets. If assets fall those returns increase.

Regulator doesn't seem able to comprehend anything with any complexity, so would much rather schemes just used AAA bond rates to discount. It may have even issued an edict to that effect in the past year or two.

It is becoming the problem.

[GoSeigen]

The folk narrative appearing in this thread (and also repeated in the FT article) of gilt yields being driven down by pension fund buying is bogus. Buying an asset does not in itself drive the price anywhere. One might as well say that the enormous issuance of gilts over the same period has driven down yields. Such a statement is self-evidently nonsense and the one about pension funds, attractive as it is to a neophyte, makes as little sense.

Gilt yields have fallen for the simple reason that buyers increasingly were comfortable with a lower yield and sellers (both the issuer and secondary market participants) naturally were happy to sell at increasingly low yield.

It is far more interesting and productive to discuss WHY purchasers were happy with such low yields than whether the mere fact of their buying (or the sellers' selling) caused yields to drop.

GS

If banks are lent funds by BofE at increasingly low interest rates, they and their hedge fund clients can be expected to gorge on the carry available in bonds, in particular gilts.

The pension funds are rather caught by the Pension Regulator's mantra that gilts are always perfectly priced and all investment decisions must be made off back of that.

Chris

Like dealtn I'm a bit lost here. Are you making a general point, or talking about the past, or talking about the future, or about some specific situation?

It seems you are seeking to draw a contrast but the detail evades me.

GS

[ChrisNix]

The folk narrative appearing in this thread (and also repeated in the FT article) of gilt yields being driven down by pension fund buying is bogus. Buying an asset does not in itself drive the price anywhere. One might as well say that the enormous issuance of gilts over the same period has driven down yields. Such a statement is self-evidently nonsense and the one about pension funds, attractive as it is to a neophyte, makes as little sense.

Gilt yields have fallen for the simple reason that buyers increasingly were comfortable with a lower yield and sellers (both the issuer and secondary market participants) naturally were happy to sell at increasingly low yield.

It is far more interesting and productive to discuss WHY purchasers were happy with such low yields than whether the mere fact of their buying (or the sellers' selling) caused yields to drop.

GS

Like dealtn I'm a bit lost here. Are you making a general point, or talking about the past, or talking about the future, or about some specific situation?

It seems you are seeking to draw a contrast but the detail evades me.

GS

If banks are lent funds by BofE at increasingly low interest rates, they and their hedge fund clients can be expected to gorge on the carry available in bonds, in particular gilts.

A key 'reason that buyers increasingly were comfortable with a lower yield'.

The pension funds are rather caught by the Pension Regulator's mantra that gilts are always perfectly priced and all investment decisions must be made off back of that.

Just a backhander at the Regulator. But for its pressure the schemes might have had the gumption to sell gilts when yields got to such absurd levels. Hard to see how they thought the puny income thereon would be able to fund much of their benefit outflows.



Hope my comments make clearer.

Chris

Moderator Message:
Phantom quotes removed.

TJH

[dealtn]

The folk narrative appearing in this thread (and also repeated in the FT article) of gilt yields being driven down by pension fund buying is bogus. Buying an asset does not in itself drive the price anywhere. One might as well say that the enormous issuance of gilts over the same period has driven down yields. Such a statement is self-evidently nonsense and the one about pension funds, attractive as it is to a neophyte, makes as little sense.

Gilt yields have fallen for the simple reason that buyers increasingly were comfortable with a lower yield and sellers (both the issuer and secondary market participants) naturally were happy to sell at increasingly low yield.

It is far more interesting and productive to discuss WHY purchasers were happy with such low yields than whether the mere fact of their buying (or the sellers' selling) caused yields to drop.

GS

Like dealtn I'm a bit lost here. Are you making a general point, or talking about the past, or talking about the future, or about some specific situation?

It seems you are seeking to draw a contrast but the detail evades me.

GS

If banks are lent funds by BofE at increasingly low interest rates, they and their hedge fund clients can be expected to gorge on the carry available in bonds, in particular gilts.

A key 'reason that buyers increasingly were comfortable with a lower yield'.



The pension funds are rather caught by the Pension Regulator's mantra that gilts are always perfectly priced and all investment decisions must be made off back of that.

Just a backhander at the Regulator. But for its pressure the schemes might have had the gumption to sell gilts when yields got to such absurd levels. Hard to see how they thought the puny income thereon would be able to fund much of their benefit outflows.



Hope my comments make clearer.

Chris

Moderator Message:
Phantom quotes removed.

TJH

And again.

What is this mysterious lending of funds by the BoE to Banks. And what is this carry trade on which they are gorging?

I note you say "If" so maybe you concede it doesn't happen but that makes it an odd contribution. So please explain and describe this process and the money flow attached to it, which you appear to think is a contributer to something negative, or an "unfair" advantage the banks (and the "chummy" clients) are taking advantage of.

[GoSeigen]

Chris Nix, I also don't see the banks borrowing from the BoE to any great extent. Lending, yes, in the form of monetary balances, but not borrowing. Their funding by and large comes from depositors. So again, are you predicting that a carry trade will start now that gilt yields are higher? And how will banks borrow from the BoE if there is no lending program (that I can see)? And how does this all tie in with extreme private-sector aversion to borrowing over recent years?


GS

[ChrisNix]

Chris Nix, I also don't see the banks borrowing from the BoE to any great extent. Lending, yes, in the form of monetary balances, but not borrowing. Their funding by and large comes from depositors. So again, are you predicting that a carry trade will start now that gilt yields are higher? And how will banks borrow from the BoE if there is no lending program (that I can see)? And how does this all tie in with extreme private-sector aversion to borrowing over recent years?


GS

GoS,

Apologies (again!) for rather misleading short hand.

When QE occurs the 'printed money' ends up in the banks' balance sheets as deposits. With base rates so low the rates on same are almost zero.

So banks ended up with billions of almost zero cost liquidity. Some of that they used to buy longer term gilts for their own book. Even 25bp is very profitable on billions. Billions lent to hedge funds at small margin. Hedge funds then loaded up on same longer term gilts. Managers get 20% profit share on the carry trade. No adjustment for extreme maturity mismatch risk.

So interaction of QE and ultra low base rates had an impact of encouraging investors to hold such gilts notwithstanding the paltry gilt yield.

As the base rate has increased the gilt yield which allows profitable carry has risen, and I suspect the availability of funding is much scarcer.

So very much an aberration of the last decade.

I expect someone in the game could explain things much better!

As for private sector aversion to borrowing, maybe with so much of banks' balance sheets utilised for such financialisation, and with pesky regulatory requirements, maybe they found industrial lending very underwhelming -- or am I misunderstanding the question?

Chris

[GoSeigen]

Chris Nix, I also don't see the banks borrowing from the BoE to any great extent. Lending, yes, in the form of monetary balances, but not borrowing. Their funding by and large comes from depositors. So again, are you predicting that a carry trade will start now that gilt yields are higher? And how will banks borrow from the BoE if there is no lending program (that I can see)? And how does this all tie in with extreme private-sector aversion to borrowing over recent years?


GS

GoS,

Apologies (again!) for rather misleading short hand.

When QE occurs the 'printed money' ends up in the banks' balance sheets as deposits. With base rates so low the rates on same are almost zero.

So banks ended up with billions of almost zero cost liquidity. Some of that they used to buy longer term gilts for their own book. Even 25bp is very profitable on billions. Billions lent to hedge funds at small margin. Hedge funds then loaded up on same longer term gilts. Managers get 20% profit share on the carry trade. No adjustment for extreme maturity mismatch risk.

So interaction of QE and ultra low base rates had an impact of encouraging investors to hold such gilts notwithstanding the paltry gilt yield.

As the base rate has increased the gilt yield which allows profitable carry has risen, and I suspect the availability of funding is much scarcer.

So very much an aberration of the last decade.

I expect someone in the game could explain things much better!

As for private sector aversion to borrowing, maybe with so much of banks' balance sheets utilised for such financialisation, and with pesky regulatory requirements, maybe they found industrial lending very underwhelming -- or am I misunderstanding the question?

Chris

Okay, I think I've got it now: you are saying that over the last decade or so UK banks have been using customer deposits as carry (due to zero monetary rates) to purchase gilts and boost their profits. I have done no checks on this but can believe they might do so as it's practically what I have done in my portfolio (but obviously without the customer deposits, nevertheless I have been running tens of thousands of almost 0% interest credit card debt). However I hope the banks, like me, unloaded all their longer dated gilts two or three years ago! If not they may have wiped out a fair amount of those gains...

GS

[XFool]

I see from today's FT that the DB pension Lifeboat Fund is one of the main users of LDI in the UK and has been forced to sell off assets to raise cash.

[Alaric]

Here's a report about the Bank of England and the LDI crisis.

https://www.theguardian.com/business/20 ... t-meltdown

One thing puzzled me a little.

They say

Had the Bank not intervened with a promise to buy up to £65bn of government debt, funds managing money on behalf of pensioners across the country “would have been left with negative net asset value” and cash demands they could not have met.

“As a result, it was likely that these funds would have to begin the process of winding up the following morning,” the Bank said.

Surely if a pension fund is forced to wind up it takes the sponsoring Company with it? Not a desirable outcome. for market stability. After all was it not to avoid paper losses on Gilt holdings when interest rates fell that schemes were pushed in the direction of LDIs in the first place? The point being that said losses would otherwise show up in the Company's disclosed financial results.

[ChrisNix]

Here's a report about the Bank of England and the LDI crisis.

https://www.theguardian.com/business/20 ... t-meltdown

One thing puzzled me a little.

They say

Had the Bank not intervened with a promise to buy up to £65bn of government debt, funds managing money on behalf of pensioners across the country “would have been left with negative net asset value” and cash demands they could not have met.

“As a result, it was likely that these funds would have to begin the process of winding up the following morning,” the Bank said.

Surely if a pension fund is forced to wind up it takes the sponsoring Company with it? Not a desirable outcome. for market stability. After all was it not to avoid paper losses on Gilt holdings when interest rates fell that schemes were pushed in the direction of LDIs in the first place? The point being that said losses would otherwise show up in the Company's disclosed financial results.

Letter can be sourced from here: https://committees.parliament.uk/commit ... committee/

[Alaric]

[

Letter can be sourced from here

from which

The Bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value. As a result, it was likely that these funds would have to begin the process of winding up the following morning.

The word "fund" is used with multiple meanings. In this case it means the LDI collective that would be wound up, not as some newspapers seem to be suggesting, the pension fund. I would hope pension funds hold LDI funds on a limited liability basis. In other words their exposure is limited to the value of the LDI holding, rather than there being an unlimited liability for the scheme sponsor to support the LDI manager.

[dealtn]

Chris Nix, I also don't see the banks borrowing from the BoE to any great extent. Lending, yes, in the form of monetary balances, but not borrowing. Their funding by and large comes from depositors. So again, are you predicting that a carry trade will start now that gilt yields are higher? And how will banks borrow from the BoE if there is no lending program (that I can see)? And how does this all tie in with extreme private-sector aversion to borrowing over recent years?


GS

GoS,

Apologies (again!) for rather misleading short hand.

When QE occurs the 'printed money' ends up in the banks' balance sheets as deposits. With base rates so low the rates on same are almost zero.

So banks ended up with billions of almost zero cost liquidity. Some of that they used to buy longer term gilts for their own book. Even 25bp is very profitable on billions. Billions lent to hedge funds at small margin. Hedge funds then loaded up on same longer term gilts. Managers get 20% profit share on the carry trade. No adjustment for extreme maturity mismatch risk.

So interaction of QE and ultra low base rates had an impact of encouraging investors to hold such gilts notwithstanding the paltry gilt yield.

As the base rate has increased the gilt yield which allows profitable carry has risen, and I suspect the availability of funding is much scarcer.

So very much an aberration of the last decade.

I expect someone in the game could explain things much better!

As for private sector aversion to borrowing, maybe with so much of banks' balance sheets utilised for such financialisation, and with pesky regulatory requirements, maybe they found industrial lending very underwhelming -- or am I misunderstanding the question?

Chris

Very little of these liabilities are matched by banks with Gilt purchases. Banks typically will only buy gilts for their own books for a liquidity portfolio and to satisfy the regulator with respect to capital. The average duration would be about 2-3 years, certainly not long gilts. They won't be lending billions to hedge funds either, and certainly not at low margin. I think you might need to understand the functions of banks better. (25 years working for a bank mostly in fixed income, and their derivatives).

[ChrisNix]

Chris Nix, I also don't see the banks borrowing from the BoE to any great extent. Lending, yes, in the form of monetary balances, but not borrowing. Their funding by and large comes from depositors. So again, are you predicting that a carry trade will start now that gilt yields are higher? And how will banks borrow from the BoE if there is no lending program (that I can see)? And how does this all tie in with extreme private-sector aversion to borrowing over recent years?


GS

GoS,

Apologies (again!) for rather misleading short hand.

When QE occurs the 'printed money' ends up in the banks' balance sheets as deposits. With base rates so low the rates on same are almost zero.

So banks ended up with billions of almost zero cost liquidity. Some of that they used to buy longer term gilts for their own book. Even 25bp is very profitable on billions. Billions lent to hedge funds at small margin. Hedge funds then loaded up on same longer term gilts. Managers get 20% profit share on the carry trade. No adjustment for extreme maturity mismatch risk.

So interaction of QE and ultra low base rates had an impact of encouraging investors to hold such gilts notwithstanding the paltry gilt yield.

As the base rate has increased the gilt yield which allows profitable carry has risen, and I suspect the availability of funding is much scarcer.

So very much an aberration of the last decade.

I expect someone in the game could explain things much better!

As for private sector aversion to borrowing, maybe with so much of banks' balance sheets utilised for such financialisation, and with pesky regulatory requirements, maybe they found industrial lending very underwhelming -- or am I misunderstanding the question?

Chris

Very little of these liabilities are matched by banks with Gilt purchases. Banks typically will only buy gilts for their own books for a liquidity portfolio and to satisfy the regulator with respect to capital. The average duration would be about 2-3 years, certainly not long gilts. They won't be lending billions to hedge funds either, and certainly not at low margin. I think you might need to understand the functions of banks better. (25 years working for a bank mostly in fixed income, and their derivatives).

I know well an ex banker whose bank bought various bonds in substantial amount on book for carry trades. Pretty sure some were gilts and some were much greater than 3 year tenor.

But to stick to the underlying point, even if there was/were a middle man/men involved, do you deny that a substantial amount ended up funding hedgies (and analagous structures) playing the carry trade?

[ChrisNix]

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.

An excellent summation, in particular on history!

Oversimplified in parts, but most posts have to be.

LDIs did serve a purpose, but there was an escalating probability that things would rebound, which became a near certainty as time went by.

If someone had come to me in February with 30 year gilt yields at say 1% and inflation having pierced 5% and offered to sell me a 2:1 geared bet on 30 year gilt prices I'd have told them they were smoking strong ganga.

By the same token, there is and was a time to take off hedges.

[dealtn]

But to stick to the underlying point, even if there was/were a middle man/men involved, do you deny that a substantial amount ended up funding hedgies (and analagous structures) playing the carry trade?

Yes

[dealtn]

By the same token, there is and was a time to take off hedges.

Not on the mandates those pension funds operate to, especially when the vast majority were under hedged.

[ChrisNix]

But to stick to the underlying point, even if there was/were a middle man/men involved, do you deny that a substantial amount ended up funding hedgies (and analagous structures) playing the carry trade?

Yes

Not sure where we go with this as quite a lot of anecdotal evidence out there.

Not sure you'd know, but who do you think were bidding for the 2073 index linkers on issue last year?

GBP1.1bn face issued at GBP3.9bn.