Con Keating has produced a remarkable blog on the issues around DB funding –Anthony Hilton’s original piece continues to make waves it has received more comment – this is Con’s response. If you cannot access Dan Mikulskis’ comments via the link, they are appended to Anthony’s article

Doubtless Dan Mikulskis and his colleagues are sincere in their beliefs; the fervour of their defence of them is positively religious, and likely as well-founded an ideology.

Social psychologists use the theory of motivated beliefs to explain such behaviour. Motivated beliefs are quite distinct from the sociologists’ intrinsic and extrinsic motivation, which figure prominently in the analysis of trust.

Here, people still pursue their self-interest but may have multiple and sometimes conflicting goals. To quote Epley and Gilovich: “People generally reason their way to conclusions they favour, with their preferences influencing the way evidence is gathered, arguments are processed, and memories of past experience are recalled. Each of these processes can be affected in subtle ways by people’s motivations, leading to biased beliefs that feel objective (to them)”. As Oxford’s Tim Taylor has pointed out “The crucial point is that the process of gathering and processing information can systematically depart from accepted rational standards because one goal— a desire to persuade, agreement with a peer group, self-image, self-preservation—can commandeer attention and guide reasoning at the expense of accuracy.” There is more: “A person who recognizes that a set of beliefs is strongly held by a group of peers is likely to seek out and welcome information supporting those beliefs, while maintaining a much higher level of scepticism about contradictory information.”

In this world view, control of the narrative and the suppression of progressive, ‘difficult’ journalists are routine.

Dan begins with the assertion that we face an “unprecedentedly difficult macroeconomic environment”. We face no such thing. In the 1970s we faced three-day working weeks, rolling electricity blackouts, petrol shortages and millions of days lost to strikes. There was serious, if sotto voce, talk of a military-backed coup; sterling required exchange controls and an IMF bail-out.

Private sector non-financial companies saw their returns on capital fall as low as 4%, in a year when inflation exceeded 12%. The FT index reached a low of 146, down 73% from its high. Gilt yields reached 17%, inflation over 20%. DB schemes had 11.4 million members, and their longevity was already increasing at post-millennium rates. Of course, there was a banking crisis, but no pensions crisis.

Since then, the rate of corporate insolvency has fallen dramatically, from nearly 2% annually to a recent 0.4%. Reassuringly, this means that the need for the PPF has never been lower. His assertion that sponsoring companies “face tough choices” when private sector returns on capital exceed 12% p.a. and dividend payments are an all-time record high has ‘truthiness’ but no more.

Dan takes exception to the idea that the discount rate should reflect the expected return on assets; so do I. In fact, Jon Danielsson and I, in meetings with regulators and in the columns of VOX-EU, argued extensively against the introduction of the ‘matching adjustment’ to the discount rate used in life company regulatory evaluations. Our views did not prevail, which means that there is an argument here, not used by Anthony Hilton, for a level playing-field.

But the use of gilts or AA corporate bonds is equally inappropriate. The use of a particular discount rate does not result in the transfer of the properties of the asset class from which it was derived to the pension liabilities being discounted. Using a risk-free rate does not confer risk-free-ness; that would require belief in financial transubstantiation.

In fact, as the concern is with corporate insolvency, the appropriate discount rate should be bankruptcy-consistent (admitted claims), not market-consistent. This rate is determined, at time of award, by the contribution made and the benefits promised. It is extremely stable, moving only as benefit projections are revised. It is part of the promise made by the company. Most importantly, it is equitable to other creditors. It paints a very different picture from gilt yields.

The obvious problem with assertions such as “Today’s unfortunate reality is that the defined benefit system in the UK is on average under-funded compared to the benefits it has promised”, is their self-referential circularity. This may be true under the current protocol, but lacks objective, independent supporting evidence. With a little more thought, we can see it is actually support for the use of the sponsor-promise based metric.

No charity is afforded journalists; the narrative has taken hold. It is past time to correct this, but, make no mistake, the motivated beliefs are well-entrenched.

Some would call it a storm in a tea-cup, some the great pension debate of our time. This morning I am publishing Anthony Hilton’s tirade against actuarial valuation methods, Dawid Konotey-Ahulu’s refutation and by way of synthesis, this article by Con Keating, regular guest blogger on this site.

Oblate spheroids and complete balls.

Dawid’s blog, in response to Anthony Hilton’s concerns with current pension accounting and management, is amusing, but it takes almost a thousand words to reach its first material issue with Anthony’s position. There is such a thing as taking a joke too far; and that seems an apposite description of the situation with DB pension schemes. For the avoidance of any doubt, I shall state my position here: I shall continue to think of the earth as an oblate spheroid, as I find Dawid’s circular arguments less than convincing.

Let us begin by unpacking: “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.” The whole thrust of the disagreement and argument centres on the mismanagement of pension schemes arising from their mismeasurement under current protocols.

However, Dawid has also sneaked in the idea that full funding should be an objective. The promise has never been: I promise to pay you 1.5% of your final salary for life in retirement, and I promise to maintain a fund or any other such nonsense. The promise was clear; it was the right to an income in retirement. Why Dawid should specify full funding is not at all clear either, given that a fully-funded fund, were it unsupported, would have a fifty percent chance of failure prior to the discharge of all pensions. In common with many, Dawid persistently describes the present value of liabilities as the liabilities, an estimate however derived; a cynic might take this as an attempt to lend credibility to those figures.

The arrogance of that next “deep understanding” sentence is, at first sight, breath-taking, but of course becomes far less so when we realise that the complexities involved have been created by those who wish to ‘provide solutions’. The pension promise was made, and accepted, independently of any assets or investment. In fact, it is only by trying to match the sensitivities of the market value of assets to those of the present value of liabilities derived under bizarre protocols that these complexities are introduced, and of course, these are the illuminati of the protocol.

Dawid’s blog continues with: “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.”  The self-referential nature of these assertions renders them fatally flawed and of no argumentative substance. Some pension schemes did some time ago buy into the matching of assets and the present value of liabilities under the current protocols, and it is reassuring that the illuminati were sufficiently competent that under these protocols they were successful. However, the immediate question is: at what cost were these successes achieved? The schemes in “dark and dangerous places” are in fact only in these places under these protocols and Dawid provides no objective evidence outside of these protocols that this is a dark or dangerous place.

The blog then invents some history:

“Some background:

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 would actually 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.”

This is a rewriting of history; the new narrative. Companies, or rather their actuarial advisors, did do the mathematics at the time of award, and those awarding inflation linking explicitly considered this. Benefits have risen because of unexpected and sustained increasing longevity and the statutory requirement introduced to offer limited price inflation linking affected schemes which had not previously offered this. The agenda here is to maintain that DB pensions are now and always were unaffordably expensive; they were not and are not. Do the maths. In recent times the overwhelming majority of the increases in DB pension provision cost have in fact come about as a result of actions associated with liability ‘management’ such as closure to new members and future accrual.

The blog continues with a further narrative surrounding the equity risk premium, that is so tired from overuse that I will pass over it. It is notable that this section of the blog is illustrated with share prices rather than cumulative returns, which are nowhere near as alarming. It also shares the problem of being self-referential or circular.

“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.” No-one has changed the rules of mathematics; they did introduce an inappropriate, incorrect and pernicious protocol. Moreover, the mathematics done at the time of award was fit for purpose under the protocols and practices then prevailing.

“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.” There are at least four alternative protocols which might be employed for the analysis of pension schemes and their funds. For example, Paul Boyle, then CEO of the FRC, began a speech on this topic in 2009 by considering measurement in terms of future values rather than the discounted present value now employed. There are also many who employ cash flow analysis in the best traditional of financial analysis. We might also use the bankruptcy-consistent approach advocated in Keating, Settergren and Slater, ‘Keep your lid on: A financial analysts view of the cost and valuation of DB pension provision‘; this is certainly accepted as it is the process employed by the courts. Moreover, we should not forget that the Local Authority Pension Fund Forum obtained a formal opinion from Mr G Bompas QC which considers that the current protocol breaches the more fundamental requirement of company law that accounts should present a ‘true and fair’ view of affairs. In other words, the existing protocol is very far from accepted, and certainly not unique.

The blog continues with a bizarre meandering around rogue traders and suggests that a pension fund deficit is in some way equivalent to a short position in marketable securities or derivatives. This is complete nonsense; the company has promised to pay its former employees an income in retirement, no more, no less.

The continuation grows ever more strange: “We have a collective obligation to make absolutely certain that pension plans can pay those benefits. Inflation-linked and all.”  Where did that come from? Perhaps more importantly, how might any of the nostrums of the illuminati help that come about?

“Pension funds are fully responsible for taking decisive action to ensure they can pay everyone what they are due to receive”. This is simply not true; this is not a fiduciary or other obligation of scheme trustees. In any event, should the pension scheme be unable to meet pensions on time and in full, it has recourse to the sponsor employer.

“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.” Pension funds have no such obligations; schemes might, under the most charitable of interpretations, but that sloppiness just typical of the prognostications of members of the illuminati. Truthiness is all. Note that now they have to hedge; a further untruth.

“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!” Dawid has failed to consider the sponsor position; most corporate sponsors are exposed to and gain from inflation. The net position between the limited price inflation of pensions and the full price inflation in the economy works to the advantage of these sponsors. In this regard, and many others, the protocols under which schemes are valued and now managed add to the real risks faced by a sponsor. The last sentence is most intriguing; the illuminati claim to be able to manage (close out) the unmanageable. This makes base metal into gold look viable.

But there are yet more internal inconsistencies such as “There is very little growth and no inflation to speak of.” which might equally be expressed as: so all the hedging of inflation about which the illuminati are so proud has been pointless. They have hedged a risk that has not materialised. But these illuminati don’t want to recognise the fact that one of the few things known about risk is that it means that more things may occur than will. Risk is the bogeyman with which to scare the children, or in this case, trustees.

Then of course, having criticised the equity risk premium at length; the blog would be failing if it didn’t include at least one free lunch: “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.” The advocates of the current protocol make much of the law of one price, but here that is directly breached.

The original Anthony Hilton article is far from perfect, but as a rebuttal, this blog is incoherent and inconsistent, to the point that it is difficult to dismiss the strongly denied self-interest. The most egregious of the claims made by Dawid is that without this approach, a generation of pensioners would be facing penury: “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.” The reality is that valuation and management under this protocol has led directly to, that is caused, the closure of pension schemes and significant harm to the companies that sponsored them and with that society’s well-being. The harm done by this protocol does not merely affect current members, it extends over the generations of as yet unborn who will not be offered defined benefit pensions. It has already diminished, and in many cases ruined, the retirement prospects of many millions of people.

Dawid’s rebuttal even offers a repugnant defence: “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.” These are of course among the few that have profited from the protocol at the expense of their neighbours; these are the polluters who have poisoned the pensions environment for the world at large. I shall continue to view the world as an oblate spheroid and this rebuttal as complete balls.

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:

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.

Some background:

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.