There have been two parallel stories running this week. The first is the story that the pensions industry wants told , a story about rising standards, impending dashboards and the acknowledgement that the majority reaching retirement in DC schemes need something better than investment pathways.
The second is the story being transmitted to the Liverpool halls of the fire sale of assets as large schemes struggled to meet ever more extravagant margin calls and the mystification of small schemes, stuck in LDI pooled funds, who found their LDI protection being stripped from them without there being much they could do.
I talked with trustees, scheme executives, LDI platform managers, LDI managers and with the Regulators. Some wanted to talk to me about the good news story, some the bad. And there were and are a great number of people at this conference for whom the whole LDI story remains a mystery.
It is not for me to call out schemes, but I can say that I have spoken with tired frightened people who have worked every day round the clock since this crisis broke to minimise the damage done by the ineptitude and irresponsibility of Government and some pretty strange behavior from those within our central bank.
The fake news put out to the BBC and the FT that the Bank of England would extend emergency buying of conventional and index linked gilts beyond today should not go unpunished, we cannot have those within our central bank briefing against its Governor, it is a sign of the times, that such a thing ever happened.
As for the markets, the only thing encouraging them – and gilt yields did fall a little yesterday – is the prospect of the mini-budget being unwound in a u-turn of epic proportions.
Assessing the damage
Small pension schemes access LDI through pooled funds which manage each investor separately, so while assets are pooled, the degree of hedging varies from scheme to scheme depending on the level of collateral put up. It is clear that some small schemes have had little or no interaction with their pooled fund managers and their trustees are in the dark about the status of their hedge, the value of their pool fund and the likely cash calls to come. This can only be a resourcing issue, there are only so many account handlers able to liaise with small schemes and the law of the jungle dictates that the larger the value of client, the more attention they’ll get. When the dust settles, we will see what remains.
Pooled funds have one thing going for them relative to the segregated funds of larger pension schemes, they have limited liability, when the gilts have been sold and the hedges collapsed, the funds may be worth nothing but at least they have no toxic revenue.
This is not the case where the collateral calls are unlimited. Segregated funds can call on trustees for an unlimited amount of collateral as there is no cap on gilt yields, the present value of 1/100th of a percent of movement in the gilt yield (PV01) can amount to millions, a full percentage rise in gilt yields can mean a billion pounds or more demanded of the trustees. Trustees are being asked to put up or have their positions shut down.
My understanding is that some of the large pension schemes are now finding that their cupboards are bare, they have little or no liquid assets left to sell, they are having to sell the gilts they own, their private market investments and they are having to go to their sponsoring employers for lines of credit to stay in the market. The money paid to the banks to meet these margin calls is gone.
Amazingly, because of the perversity of the 2004 accounting standards, such schemes may still be “in surplus” and technically more solvent than they were at the start of the crisis. The happy story being peddled by the pension industry is that schemes will come out of this better placed to pay their pensions. That is true, so long as yields remain at current levels. But when – and let’s hope this is soon – yields revert to lower levels – in line with the BOE’s long term target for inflation, the damage to the asset base of our large schemes will be revealed, the cupboards will remain bare and as liabilities become more expensive to meet , there is a danger there will not be sufficient realisable assets in these schemes to pay pensions, they will be back negotiating deficit plans with their sponsors.
As Toby Nagle points out writing for FT Alphaville,
The risk of falling gilt yields from here (that would increase the present value of liabilities, but not assets) is being transferred straight to sponsors’ balance sheets.
One final point that is worth considering from talking with schemes is the relationship schemes have with the Pensions Regulator over gearing. The original idea for the hedge was to get schemes through a short-term depression in gilt yields and that business as usual would be the removal of derivatives from schemes when they were no longer needed. At some point the Regulator moved from accepting gearing as a short-term fix to encouraging the use of LDI as a long-term investment strategy to a point where it questioned why schemes did not leverage their bond holdings.
Now the Pensions Regulator has put the engine in reverse. This from the FT’s Conference briefing
With this programme due to end on Friday, The Pensions Regulator was asked whether defined benefit pension schemes were prepared for the programme to end, in terms of the collateral levels being restored.
“There’s still a lot to be done over the next 24 (plus) hours,” said Charles Counsell, chief executive of The Pensions Regulator,….
“I hope we will be in good shape at the end of that period.”
I hope so too, Charles Counsell reassures us, but this feels like the blind leading the blind.
Such processions are the stuff of group think and the results are distressing.
I spoke to one finance officer of a small scheme yesterday who said she was in the process of implementing an LDI contract this summer , ditching her incumbent manager , selling real assets and swapping them for an LDI strategy, this under the advice of a well known consultancy. Even as we were seeing schemes meeting their first margin calls, it appears that LDI contracts were being set up.
I spoke to the CEO of a large scheme whose cupboard is now bare and asked her what comfort she was giving her disinvestment team. “doughnuts” – she replied.
I spoke out against the heterodoxy of LDI at the PLSA conference because there is no reason for pensions to hide the pain.
The stories of the pain that schemes have gone through these past weeks is now coming out
Processing hold-ups at US custody bank exacerbated UK pension sell-off
I find myself in agreeing with John Ralfe as to the problem, though simply relying on gilts to fund our pensions seems the wrong solution.
Investigation needed to hold those behind UK pension crisis to account
Taxpayers should not bail out companies that have been speculating
Harvard predicts looming markdowns to private fund holdings
Schemes should not think they will be able to hide behind unadjusted valuations of privately held investments. The FT reports that losses at the university’s $51bn endowment could widen as private equity and venture capital funds cut valuations.
Meanwhile we are consulting on regulations which are designed to maintain and actually increase the received idea that LDI is a de-risking strategy. The FT asks
Are we doubling down on systemic risk in pensions?
…the thrust of the government’s proposals should sound familiar. It wants stricter, legally-binding requirements for pension schemes to improve funding as members hit retirement, and to adopt a “low dependency” strategy that cuts investment risk. That means a reduced likelihood of calling on the company sponsor for additional support. Such a strategy involves matching cash flows from investments to pay liabilities, usually by buying government bonds, and insulating schemes from short-term changes in market conditions. In other words, LDI.
The grim irony should not escape those waking up with a hangover after the PLSA Conference dinner.
I will simply point out an aspect of LDI which passed without comment at the time. During the declines in gilt yields, the self-same spiral that is increasing demands for collateral now, was supplying it to schemes and it was being invested (which incidentally is borrowing by the scheme) in more gilts – which of course helped drive gilt yields down more than would otherwise have been the case. The evidence was screamingly evident – index linked gilts at rpi minus 300 basis points
The earth is flat. Gilts are risk free.
When building a typical house on a 10mtr X 10mtr plot the foundations are vital – it must be level, and a good old bubble spirit level will be used to check the plot is level and flat. The plan or model for the house can assume the earth is flat.
When building a larger structure like a bridge, such as say the new Queensferry crossing across Forth estuary, levels will be checked with a laser. But importantly over is 1.7mile span there is drop of around 14 inches from one side to the other of the new bridge – the curvature of the earth is around 8 inches per mile. Putting aside the flex in the materials, its vital the engineer is aware of the bigger picture taking into account the 14 inches drop in setting the foundations – otherwise they will be weak and will not survive the stress and turmoil. The plan or model for the larger structure needs to look at the bigger picture – the earth is not flat.
So be it with pensions. For a single pensioner (or scheme) it is good enough to assume that gilts are risk free and to secure a pension on that basis – and from a societal perspective its important too, as the pensioner typically has less ability to replace lost income from investments. Compared to or relative to the other investment alternatives for the pensioner, it is a reasonable simplification (or modelling assumption) to consider that gilts are risk free.
But the flaw is in extending that risk-free modelling assumption to an entire system, and especially a 21st century system in which the aggregate scale of pension requirements are no longer a mere appendix to the economy, but (because of ageing demographics and longevity) their scale has made them a cornerstone of the economy. Investing in gilts, is investing in the State, and over the longer term the payment of gilt supported pensions depends on a functioning economy with sufficient tax raising powers. It’s a political judgement as to the amount of pension assets that should be invested in the State, and what should be invested in growth assets (hitherto a dirty or risky word in pension models). That’s not to say schemes should not invest in gilts or the state, but it does feel in aggregate that their investment allocations between risk capital, infrastructure and patient capital, and providing state support has become skewed, and the multiplicative effect of leveraged LDI on top of gilts has created new class of dead non-contributing capital.
The use of leveraged LDI (and please refer to the invaluable blogs from Con Keating and Ian Clacher if you’re interested in understanding this, which should be made compulsory reading for all interested in managing pension systems) was a shortsighted abuse of the single scheme assumption that gilts are risk free. Recent events have reminded all wise investors that gilts are not risk free.
Once the buck-passing has stopped and the politicians and various regulators have settled on who should have been and who will be responsible for building and overseeing the whole pension (and investment) system (as opposed to on a single scheme basis), we can but hope that by using assumptions looking at the bigger picture, the System will once again support pension schemes in their important role of investing for all our futures.
Jnamdoc has eloquently stated what I have been saying for decades that gilts are not risk free and potentially as volatile as equities. The last few years have seen the Pensions Regulator pushing for a “fast track” valuation basis for DB schemes based on Gilts + assumptions, and benchmarking bespoke valutations against fast track. TPR & DWP moved away from earlier statements last year and DWP published their revised funding regieme proposals earlier this summer. I found the wordings used to be tortuous and going round in circles, and have suggested these are not fit for purpose. I hope this latest debacle will mean the DWP / TPR revisiting their proposed funding regulations and bring back some common sense into the funding of long term liabilities.
It will be a challenge. You’d have to take flat-earthers to the moon to move their world view, and even at that the more entrenched will insist you’re a naysayer trying to trick them. But it’s import to try – copy and share, and spread the word; the earth is round😳🤣