Are bonds “suitable” assets to meet the promises of a pension plan?

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“recrudescent Ralfe syndrome”



Pension funds are struggling to find suitable assets in which to invest, says Pat Race of KPMG in an article in FTfm. The headline of the article is that “North American Pension Funds grow assets faster than their global peers.

Nobody would point to US DB plans as a model for the rest of the world, they have huge deficits and scant protection for members, but the article points to the growth coming from the strength of the yankee dollar and the investment of the funds in growth assets (e.g. equities).

The article also quotes WTW’s Roger Urwin  citing Japan’s $1.2tn Government Pension Investment Fund as an example of an investor that had improved returns after a shift in strategy. In 2014, the GPIF signalled a change into riskier assets and away from low-yielding bonds. Assets held by the world’s largest pension fund have since hit a record high.

What is suitable about bonds?

Clearly bonds are a suitable asset to buy if you want to back up a promise you are making. If you have promised to pay a school fees program for your grandchild and you know the size of the liability, then you can buy bonds which will pay the exact amount as long as the credit is good – I understand that, and I understand that the more you pay for the bonds, the more likely it is that the credit is good.

It’s easy enough for a predicable payment over five years (the school fees) but it’s harder for an unpredictable payment in 40 years time, especially if the size of the payment varies on things as strange as average life expectancy.

This is why, investors of yore, decided that the most sensible way of meeting their promises was betting on the growth of their economy by investing in things getting better. This broad philosophic concept translated into assuming that equities would grow in value as companies prospered in a growing economy. The idea of diversification took hold as people realised that simply investing in a local economy meant putting too many eggs in one basket.

Diversification into bonds and alternative assets happened because of the changing nature of the liabilities – which became more pressing as our pension funds grew, but there was not – until recently – that perception that pension funds were finite and that payments would come to an end.

While bonds are a suitable way to match promises for school fees, where the child’s education finishes and other’s does not begin, they are not suitable for pension funds where thousands of new members are created just as thousands die.

The internal rate of return

The most interesting part of the management of a pension scheme is how the promises are made in the first place. It is a general maxim you do not make promises you cannot keep, though we may not have made them, we must assume that the defined benefit promises made by those older than us, were meant to be kept and that people assumed that the original investment strategies were meant to fund them in full.

Con Keating, who is a “bonds man” spends a lot of time thinking about how those founding fathers assessed their capacity to meet the promises and has come up with a word “accrual” which he uses to explain the long-term internal rate of return that the founders would have needed to pay in full.

That return assumed a regular payment from the sponsors of the plan (employer and member) and a consistent treatment of assets by the Government (tax). This was part of the deal. By and large the deal has been broken, tax on equities was introduced by Gordon Brown, employers took contribution holidays and members are now being asked to pick up a higher proportion of the original “accrual rate”.

Employer representatives (such as unions) are right to point to the past and ask why today it is those who have broken the promises, who are calling the shots. The internal rate of return (as Con keeps telling us) , is not “time variant” ; it is the same today as it has always been. It should be what values people’s property rights (nowadays measured as transfer values) and it should be the measure which – when properly applied, values the obligations of employers to their pension schemes (and so to its members).

A long-term obligation

I often hear people (mainly those in Reward) wondering why so much company money is spent on the pensions of people who have left, as if those people were no business of the company any more.

This is to misunderstand the basis on which the original promises were made. As with marriage vows , so with pension promises, they may be severed for the future but they apply forever – for the period of the marriage.

I am no fan of divorce but -as a twice divorced man – I believe absolutely in the sanctity of the promises I made when I married and of my legal obligations when I got divorced.

Those who think that deferred members of pension schemes can be treated as second class members are greatly mistaken. The Government found against the “active member discount” precisely because past members of a pension arrangement do not lose rights when they leave a job (unless in extreme circumstances such as gross misconduct).

The rights bestowed on us, once vested, are inalienable. The attempts to retrofit changes (perhaps with the exception of the mucking about between RPI and CPI, have failed). A promise is a promise.

Why then, when we expect the nature of the original promise, do we not respect the way the promise was meant to be repaid? Why did we have contribution holidays, why should de-risking involve members getting lower benefits or paying higher contributions?

When most of these promises were made -in the middle of last century, no-one could have imagined the economic situation today. I expect most people then would marvel at our lifestyles today and the capacity of employers to pay staff to meet them.

I suspect that the promises made in those days, for all the increases in life expectancy, were realistic then and are realistic today.

What has changed is the means we employ to meet them. We have stopped looking to the future with courage and optimism and started thinking of failure. We assume the deficits we imagine are real and that they cannot be staunched. We believe investing in real assets is reckless and should not be done. We have so collapsed our view of what a pension scheme can do, that we can find no suitable assets with which to do it!

Pensions are long-term obligations which can only be met by long-term thinking and long-term investment! Bonds are not part of the long-term equation and are not suitable as the base with which to run a forward-thinking pension scheme.


Comments very welcome!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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