This is the second of three blogs published this morning that all focus on the same thing, the funding of our Defined Benefit Schemes.
It’s written by Dawid Konotey-Ahulu, Founder of Redington and Mallowstreet. Anthony Hilton’s original can be found here, Con Keating’s synthesis of the two blogs can be found here.
This blog first appeared on Dawid’s “Just Saying” blog, you can read the original here
“The Earth is Flat”
The Flat Earth Society is a fabulous organisation dedicated to “unravelling the true mysteries of the universe and demonstrating that the earth is flat and that Round Earth doctrine is little more than an elaborate hoax.”
As the Flat Earth Society explains:
“Throughout the years it has become a duty of each Flat Earth Society member, to meet the common Round-Earther in open, avowed, and unyielding rebellion; to declare that his reign of error and confusion is over; and that henceforth, like a falling dynasty, he must shrink and disappear, leaving the throne and the kingdom of science and philosophy to those awakening intellects whose numbers are constantly increasing, and whose march is rapid and irresistible.”
Many of the thought-provoking publications of Flat Earth thinkers are based on the work of the 19th century inventor and writer Samuel Rowbotham who, in 1849, published a 16-page pamphlet entitled Zetetic Astronomy: Earth Not a Globe. According to Rowbotham:
the earth is a flat disk centered at the North Pole and bounded along its southern edge by a wall of ice, with the sun, moon, planets, and stars only a few thousand miles above the surface of the earth.
Now, of course, that sort of thing is very easy to say, and readily dismissed, but the Flat Earth Society back up their assertionswith scientific reasoning and analysis as follows:
Perhaps the best example of flat earth proof is the Bedford Level Experiment. In short, this was an experiment performed many times on a six-mile stretch of water that proved the surface of the water to be flat. It did not conform to the curvature of the earth that round earth proponents teach.”
The Earth is not Flat, it’s Round
Notwithstanding Mr Rowbotham’s, nineteenth century, detailed, Bedford Level Experiment demonstrating beyond doubt that the earth is perfectly flat, some of us prefer to believe the contrary. That it is in fact spherical. That the sun does not circle the north pole; that the earth revolves around the sun.
The same is true of the pensions crisis. Some of us prefer to believe, despite eloquent arguments to the contrary, that it is only by measuring and managing the pension scheme’s liabilities there can be any assurance of reaching a state of full funding; that a deep understanding of the complex relationship between assets and liabilities is the sole basis for an expectation of success.
We also believe that, by virtue of managing their assets against their liabilities, there is, right now, a select group of pension funds which find themselves well-funded and relatively untroubled by vicissitudinous and capricious markets. On the other hand, those pension funds that have not carefully measured and managed their assets against their liabilities, now find themselves in a dark and dangerous place. Some of them have belatedly begun the process of hedging their pension fund liabilities and find themselves in a world of pain as they purchase insanely expensive assets to match/hedge their liabilities, (something they could and should have done years ago). It is this nightmare situation that has Mr Hilton and others foaming although, as I say, for entirely the wrong reasons.
Here is an explanation of why the management of liabilities by pension funds, far from being distorted and defying of logic, makes perfect, albeit increasingly painful, sense.
They did not do the math!
Companies that offered defined benefit pensions to their staff, had no idea when they first offered them, what it wouldactually cost to pay out those benefits. Amazing, but sadly true. Over the years, lots of people who worked for socially-minded companies like Tesco, British Airways, John Lewis, et al, accrued a stream of life-long pension benefits. Those benefits are linked to inflation – which has the effect of future-proofing them, and which is very, very expensive. All those benefits have to be paid out in due course and the numbers are mind-bogglingly enormous.
But they believed the Equity Risk Premium would deliver them from Evil
The companies and their pension funds shared a general belief in something they called the Equity Risk Premium which they defined, in essence, as “a very significant return from a basket of equities, that always materializes over the long-term“. They took comfort in this belief, because it meant that provided they invested in the large basket of equities, they would, over the long-term, earn enough in dividends and equity price appreciation to pay out all the benefits they had promised to their workers. This was akin to taking on a large mortgage in the belief that over its life, you are bound to earn enough to make all the payments. It doesn’t work like that and, unfortunately, the Equity Risk Premium didn’t materialize in sufficient quantity. In fact, between 2000 and 2010, equities went nowhere. There was no Equity Risk Premium. It was the Lost Decade!
It slowly became clear to corporations and pension funds that, far from being able to pay out their members in full and on time, the pension funds were almost certainly going to run out of money before they were able to make good their promises. They have all had to make additional contributions into their pension schemes and (as in the now notorious case of BHS) some corporations have gone bust leaving a pension fund with no visible means of support.
As I said, the essence of the problem was that across the board, well-meaning companies agreed to pay generous inflation-proof pensions without, as the Americans say, doing the math. To be fair, they did some basic math, but it was very basic and not, as the lawyers say, fit for purpose. Eventually, the math rules got changed, but by then, the lifelong benefit promises had been made.
These companies and their pension funds built up vast inflation linked liabilities
Via their pension funds, our corporations now have huge obligations owed to millions of defined benefit pension plan members, and the brutal truth is that there are insufficient assets backing those liabilities. How do we know that? Because even a cursory measurement of those liabilities when mapped against the assets held by pension schemes shows that to be true. There is no accepted measurement basis on which UK defined benefit pension schemes look healthy.
At this point, it is worth considering the Kweku Adoboli Principle.
The Kweku Adoboli Principle
Kweku Adoboli, you will recall, was the young maverick at UBS who, in 2011, cost the bank a fortune by putting on a series of “unauthorised trades”. Those trades cost the bank a cool £1.3 billion to unwind and wiped £2.7 billion from the bank’s share price which, I think you will agree, is going some. Now, here is the salient point: when UBS woke up to Kweku’s mischief, they unwound his transactions immediately and at immense cost. The cost was great, because Kweku had made huge, very specific, bets on the markets and hadn’t hedged his positions, i.e. taken equal and opposite positions by way of protection. UBS were obliged to close out each of Adoboli’s rogue trades and, as they did so, the market moved further and further away from them, i.e. it became increasingly expensive to unwind them. That’s what happens when you have to close out a gigantic short position.
Notice that UBS did not say to itself: it is going to cost us an arm and a leg to close out these transactions; instead, let’s invest in Mexican motorways, pork bellies and Indian hospitals because, in the long term, that strategy will generate enough cash to close out Kweku’s transactions. We won’t cover our short position – it’s just too expensive right now!
No. When a responsible bank (I know, I know) discovers that it has made unauthorised transactions, and now has a massive short position, it closes them out NO MATTER WHAT THE COST. Apologies for the big letters, but this is a major point. You can take a look at the SocGen equivalent for corroboration. They lost Euros 4.9 billion closing out an unauthorised short position.
In effect, pension funds have made a series of quasi-unauthorised transactions, not fraudulently, but in the sense that they collectively promised millions of people, long years of future-proofed pension payments that they didn’t hedge and they didn’t pre-calculate or properly provide for.
That’s a “short” position. You’re now short of long dated inflation linked cash flows. Many (not all) pension funds genuinely believed they could invest their way out of the short position, much as Kweku believed. But that approach hasn’t worked (due to various financial crises of one sort or another) and now, at great cost, they are finally closing out those gigantic short, long-dated, inflation-linked, positions!
The Kweku Adoboli Principle states that: If you make a contractual promise to make payments that you don’t hedge, there is a very high probability that you will come unstuck as the cost of closing out that short position soars.
The crux of Mr Hilton’s beef is that he believes it is, frankly, mad to cover the short position at current prices. As he puts it: “We forget at our peril that the calculations of pension solvency are an artificial construct“;
In effect, he is saying, “Forget about covering your short position. It’s too expensive. Invest, instead, in a range of high yielding assets and don’t lose sleep over that short position. It’s not even real! Anyone who tells you otherwise is leading you astray. Probably because they are enriching themselves by doing so.”
But that reasoning is flawed
Millions of people are heavily reliant on receiving their pension in old age. They have toiled tirelessly for years in the expectation of a pension upon retirement. As they are likely to live for many years to come, they are going to need every penny, and more. We cannot, as a society or industry, risk a state of affairs in which people do not actually receive what was promised to them. An era of high-dependency in old age lies ahead.
We have a collective obligation to make absolutely certain that pension plans can pay those benefits. Inflation-linked and all. Pension funds are fully responsible for taking decisive action to ensure they can pay everyone what they are due to receive. Hundreds of billions of pounds’ worth of pensions are at stake. This is not optional – a failure to make those payments will result in an entire generation sliding into poverty with consequences too awful to contemplate.
That’s why pension funds have to be certain they can meet their obligations. That’s why they have to hedge their short long-dated, inflation-linked positions. Because if you don’t hedge a short position it has a way of spiralling out of control. Left to its own devices, a short position will take you out. Which is what Kweku and his erstwhile employers discovered. It is also what BHS and Tata Steel have discovered.
Those liability driven investment strategies which Mr Hilton so dislikes, are in fact the mechanism by which a pension fund can close out its short position in index linked cashflows, and invest in a diverse pool of assets which offer an attractive yield. That’s the whole point of a liability driven investment strategy. You get to close out that unmanageable short position!
It wasn’t always expensive
I am genuinely gutted that I have to write this blog. The simple, inconvenient truth, is that pension funds could have closed out their short, long-dated inflation-linked positions years ago. I wrote an article in 2003 explaining what to do. I wasn’t the only one. Lots of advisers and industry participants have been banging on for ages about the need to hedge pension liabilities, and the folly of relying solely on amazing asset-performance that materializes for a couple of years and then routinely fizzles out as yet another unforeseen financial crisis assails us.
That is the flaw in the Flat Earth Approach to Pension Risk Management. It misses the point that pension funds (owing to the promises they have made to their members), have no choice but to generate very significant returns, year after year after year after year after year. It may be hyperbole on the part of Mr Hilton, but it is plainly not true that a tweak to an assumption or two can make any deficit disappear. A more considered observation might be that “a tweak to an assumption or two significantly affects the calculation of the size of the liabilities” – but that doesn’t make the calculation “an artificial construct”. If you discount the liabilities using a high rate of return (as Mr Hilton implicitly advocates) you then have to generate that high rate of return every year, for the entire life of the pension plan – or you will run out of cash. And that metronomic consistency is almost impossible to achieve. There is very little growth and no inflation to speak of. QE hasn’t kick-started the economy to the extent everyone hoped and it seems we may be settling into an Ice Age of very low yields. The low rates used to calculate pension liabilities are simply a truthful reflection of the unfortunate fact that good, safe, “yield” is ludicrously hard to come by.
In 2003, it was perfectly possible to purchase long dated inflation linked bonds at an affordable price. I know that because Iwatched and helped several pension funds do so. Since then, it has just become more and more expensive to close out that position but that doesn’t mean you no longer need to close it out! This graph shows the relentlessly rising cost of purchasing a long-dated inflation linked gilt.
The cost of purchasing a long-dated inflation linked gilt – a steady rise for the last 13 years
On a point of detail, pension funds haven’t been restricted to purchasing government bonds in order to close out their short positions; there are many other instruments that achieve the same thing at a lower cost. But they all track the price of this instrument. It is the underlying benchmark against which all safe, long dated inflation linked cash-flows are measured.
To conclude, it is utterly wrong to suggest, as Mr Hilton does, that consultants, advisers and asset managers have over the years, advised pension schemes to hedge their liabilities, because it is so lucrative for them that even sane people think that they have no choice but to follow the rules of a mad system“. Rather, it is because we have believed passionately for well over a decade that the unforgivable sin is to allow an entire generation of elderly pensioners to sink into a mire of poverty.
Ask the members of those pension funds that have finally reached full-funding and achieved the cherished buy-out whether they believe in managing the liabilities, and whether they are delighted their trustees opted to measure and manage their assets against those liabilities. Then spend some time with members of all those pension funds that thought about hedging liabilities, but didn’t, because somehow the time never seemed right.
The earth isn’t flat; it’s round. And, ignoring the pension fund’s liabilities and hoping for the best isn’t sane; it’s pretty close to the opposite.