The calls on DB pension schemes for additional cash collateral arose simply because these schemes have effectively borrowed in a secured manner. While the scale of the margin calls we have seen has accelerated hugely since last week, resulting in the Bank of England having to intervene in the gilts market a la the global financial crisis, schemes have been meeting margin calls since June this year (See Chris Flood’s excellent article in the Financial Times on the 1st of July on this )
Schemes have used repo extensively and repo is substantially secured borrowing. Under IORP Directive I Directive Article 18 (now the IORP II Directive Article 19) pension funds can only borrow for temporary liquidity purposes. The Directive has a protective purpose recognising the risks of misuse of borrowing by pension funds to gear up their investments. But, if 3 or 6 month repos are regularly rolled over, as appears to be common practice, the borrowing is no longer for temporary liquidity purposes. The UK’s transposition of that restriction into UK legislation (Regulation 5[i] of the Occupational Pension Schemes (Investment) Regulations 2005 (“Investment Regulations”)) does not convert a purposive interpretation of borrowing (ie borrowing in economic terms) into a black letter law literal interpretation. Note that the IORP Directives are part of retained EU legislation despite Brexit in UK law and so a purposive interpretation of borrowing in Regulation 5 applies.
DB schemes have also used derivatives to ‘leverage’ their portfolios; this again is substantially secured borrowing
Let us be absolutely clear, a scheme could have had its entire portfolio invested in gilts and though the prices of those gilts have declined, it would have suffered no calls for cash and had no requirement to liquidate anything.
Calls on repo arise principally because the repurchase price of the securities under repo is fixed and the market price of those securities has fallen below that price. The counterparty therefore calls for additional cash collateral to limit their risk exposure as the other side of the repo contract. We abstract from minor effects due to rising short term rates here.
Around the time we were writing about this in late May and early June of this year, we raised this issue with the Pensions Regulator; that the use of repo is secured borrowing and therefore ultra vires and something that the Regulator should be looking at closely. The response we received is reproduced below:
We understand that repo financing is structured as a sale and future repurchase of an asset and, as such, would not amount to borrowing for the purposes of the Investment Regulations.
Of course, trustees (and fund managers to whom investment decisions have been delegated) should ensure that investment decisions are consistent with the applicable requirements of the Investment Regulations and are appropriate for the scheme in question.”
But by not understanding the purpose of the restriction and where it came from, we have a Regulator who does not understand what it is regulating despite having commissioned a survey in December 2019 entitled “DB Pension Scheme Leverage and Liquidity Survey” – here : showing extensive repo and derivatives exposure.
Table 184.108.40.206 of this survey records £64.64 billion of gilts funded by repos. The survey reports total notional exposure of leveraged instruments as £498.5 billion and total assets for the sample of £697 billion.
Regulators should be concerned with the economic substance of transactions. There is more than a hint of potential blame avoidance in that second paragraph. As well as this, this reply takes a macro problem that should be the concern of a regulator and shatters it into a micro problem at the scheme level. Systemic problems are not managed with a microscope.
On the use of derivatives
Schemes have also used derivatives to hedge their ‘risks’. The use of derivatives is explicitly permitted by legislation for investment risk management purposes. Their use is warranted where the risks are real, for example, for the hedging of foreign exchange exposures on holdings of overseas securities. These currency hedging derivatives have resulted in minor calls for further collateral, due to the fall in the sterling exchange rate.
In the past days, weeks, and months, the overwhelming majority of calls have come from interest rate derivatives. However, there is no exposure to interest rates in DB pensions; they do not figure among the determinants of the pensions promised and ultimately payable to scheme members. There is naturally no interest rate exposure, or risk, in these schemes. The use of interest rate derivatives, such as swaps and forwards, introduces an interest rate risk into schemes – which has just crystallised rather abruptly and painfully.
Under IORP Directive I Directive Article 18 (now the IORP II Directive Article 19) pension funds can only use derivatives for investment purposes – not for hedging discount rates used for valuing the current amount of future pension payments. As with the restriction on borrowing, the Directive has a protective purpose recognising the risks of misuse of derivatives by pension funds (and the risks they introduce into schemes). The UK’s transposition of that restriction, in Regulation 4 of the Investment Regulations on the use of derivatives into the Occupational Pension Schemes (Investment) Regulations 2005 is incorrect. Note that the IORP Directives are part of retained EU legislation despite Brexit and so the restriction in Regulation 4 on the use of derivatives applies must be interpreted to give effect to the correct transposition of the IORP Directive restriction on the use of derivatives.
By not understanding the purpose of the restriction and where it came from, we have a Regulator who does not understand what it is regulating despite having commissioned the December 2019 DB Pension Scheme Leverage and Liquidity Survey referred to above showing extensive derivatives exposure in the small sample of schemes surveyed.( £216 billion of interest rate swaps (see Table 220.127.116.11 of the survey).
The missing piece of the puzzle
For all of the analysis that has been undertaken, there has been no analysis that highlights why interest rate risk exists in the manner that it does in the current system. Simply put, interest rates appear as discount rates in the production of present value estimates for liabilities and all of the analysis stops there. The Pensions Regulator has been actively encouraging this ultra vires ‘hedging’ practice without understanding what it was doing.
As this point is important, we repeat it. What was being ‘hedged’ was the variability in the estimates of the present value of liabilities – not the risks that a scheme would be exposed to in payment of pensions as and when they fall due. The Pensions Regulator has, for the past 17 years, been the biggest advocate of “market-based” discount rates, originally following FRS17 in 2005, with the use of an AA bond yield before moving to a gilts + methodology. The Regulatory regime has therefore confused measurement with risk and the consequences of that error are now starting to show.
We have argued (both independently and jointly) against the use of market-based and gilt-based discount rates when evaluating pension scheme liabilities for more than a decade. We have even raised our significant concerns about this with the UK Endorsement Board on the 1st of December 2021 over the adoption of IAS 19 post Brexit, as it introduces similar issues into corporate accounting. Our letter was headed: “Time to review IAS19 (Accounting for pension costs) as it does not meet the criteria for its adoption and retention including the legal requirement of being conducive to the long term public good in the United Kingdom.” In almost an entire year, we have received no more than recognition of receipt of our letter. Some aspects of the harm to the public good have just become evident.
By some irony, that letter was copied at the same time to Kwasi Kwarteng as Secretary of State at BEIS.
Unfortunately, there are no reliable statistics as to the extent of the use of derivatives and repo which severely limits the analysis which may be conducted. This is consistent with wishing something to pass unnoticed. However, it is clear that the use of derivatives and repos is widespread; estimates of £1 trillion to £1.5 trillion have been reported. Even the Pension Protection Fund reports the use of repo and derivatives in its investment portfolio.
The current accounting standards and regulatory approaches lead to absurdities. The most evident of which is considering schemes whose assets have declined in value by significant amounts, with the real risk of further falls in value, when the ultimate liabilities to scheme members are unchanged or higher, to be seen as financially stronger simply because the discount rate has risen, and the present value estimate of liabilities fallen.
As well as this, there is genuine economic loss in what we are seeing. This spills over from the world of defined benefit into the world of defined contribution, and there has been significant and lasting harm done to the retirement prospects of millions of DC savers this week.
There are many other questions which may be asked and to answer those this basic anatomy of the problem needs to be understood. It is crucial to understand the cause of the problem and not just the symptoms. One thing is clear, the Bank of England intervention has been a bail-out of those who borrowed, unwisely. The costs will ultimately be borne by the population at large.
The Bank of England intervention is welcome but this is a problem deferred, not resolved.
[i] The Occupational Pension Schemes (Investment) Regulations 2005 (OPS, 2005)
Borrowing and guarantees by trustees
5.—(1) Except as provided in paragraph (2), the trustees of a trust scheme, and a fund manager to whom any discretion has been delegated under section 34 of the 1995 Act, must not borrow money or act as a guarantor in respect of the obligations of another person where the borrowing is liable to be repaid, or liability under a guarantee is liable to be satisfied, out of the assets of the scheme.
(2) Paragraph (1) does not preclude borrowing made only for the purpose of providing liquidity for the scheme and on a temporary basis.