Let’s unpick this headline , statement by statement.
Do we need a rethink of pensions?
Undoubtedly we do , the current pensions regime is under review and the DWP have drafted some draft regulations which are supposed to make them safer. These regulations have met considerable opposition, particularly from leading pension experts Willis Towers Watson. Ironically, compliance with these regulations would force pension scheme to be more rather than less dependent on gilts.
Do gilts increase rather than reduce risk?
The gilt rate represents the cost of borrowing for the Government, normally Government’s borrow cheaply because they don’t default on debt. Currently the markets are marking up the cost of Government borrowing because they see it as irresponsible and incompetent.
This doesn’t mean that the fundamental reason for buying gilts has gone away, they normally pay a yield that is low but safe. Gilts become risky when packaged into LDI contracts which double , triple or quadruple the risk when something goes wrong. The problem that the pensions regime has is that two thirds of all defined benefit pension schemes have been at it.
So why have gilts been so popular? The answer is that the accounting standards to which pension schemes report , and have done since 2004, make holding gilts the best way of demonstrating solvency of a scheme. But as Terry Smith (the boss af Fundsmith) has shown, where an employer is prepared to stand behind a scheme, a more risky strategy can be more rewarding.
And what do we make or a risk free asset that can do this?
As anyone who has found themselves in a standalone “pre-retirement” fund , losing 20% in a year leading up to your wanting your money, is not a pleasant experience.
Gilts are risky assets , no matter their matching properties. Doubling or tripling down on gilts is a risky business. LDI is a risky strategy and pension schemes that have embraced it are now at risk of losing their hedge, their collateral and even their solvency.
Is the pension regulator a weak and captured watchdog?
Let’s hear what Ruth Sunderland has to say
The Regulator promised that lessons would be learned and its powers in regard to reckless employers have been strengthened. The UK is no stranger to pension scandals, from Robert Maxwell to Equitable Life. But LDIs dwarf the lot combined and the Regulator is out of its depth.
That no one knows how big the potential write off of collateral, the sell down of equities and the cash calls on employers are . is evidence that this crisis is out of control.
I sat and watched as TPR CEO Charles Counsell explained to an audience eager to be reassured that there was really nothing to see. That was because TPR have are blindsided.
They have been captured by circumstances that they will say were beyond their control but which happened under their noses.
Why does LDI dwarf the lot?
We don’t know what has been sold to meet collateral calls. JP Morgan are saying £149bn, which looks a precise number until you remember that there are 9 zeros behind a billion.
I suspect the figure is a lot higher and while some of that money will revert to the scheme, an indeterminate amount won’t.
The reorganisation of asset strategies now involves such exotics as “synthetic equities”. We are in unchartered waters.
Is the Regulator out of its depth?
A smiling and calming CEO , an urbane head of policy, a charming and charismatic Chair, all very much on display in Liverpool, but the damage that has been done to the system has happened in countless meeting where case-workers have co-erced schemes into LDI strategies that worked for a decade but blew up in a few days
Are we all in it together?
LDI is investment for dummies – it’s a decent and simplified model designed to be rolled out on mass and that works under most ‘normal’ circumstances.
The accounting issue is a symptom not the cause of the problem. Accountants like to build their own simplified models to measure and standardise things, but then look to shape the world through that simplified view.
The fundamental issue is about the design of the whole DB system, and whether we are all in it together? Do we accept that all generations need to work together to build and support an economy capable of providing decent old age non-working wage for all?
LDI is but the manifestation of the existing flawed model that seeks to provide an economic priority to the elderly at the expense of the working young. The current model has broken down because of the (hitherto unseen to the public) enormous scale of DB pensions – as we’ve heard there is c£3trn in private sector DB (and likely a similar amount in governmental DB pension) and the mis-allocation of capital therein. LDI has scheme by scheme, and with some honourable intentions, sought to allocate much of that £3trn into secure or “risk-free” assets, and indeed the Regulatory pressure was/is progressively encouraging / pushing more of the £3trn in that direction. But £3trn invested in LDI (i.e. by on large and in effect investment in the State) creates a huge dead weight on the rest of the economy, and as we’ve seen it is not “risk-free”. Investing in the State is not risk free.
LDI is a Statist one-size fits all solution to provide pensions. And this is perfectly ok if that is what a democratically elected Govt and policy makers have decided is the best use of that (£3trn) pension scheme capital. But I do not think even the proposed beneficiaries (pensioner and those approaching pension age) expect, wish or realise that so much of their pensions is invested in and now dependent upon the State? I fear however that what we have witnessed over recent times has been a damaging example of mission creep combined with unaccountable group think. The Regulator, as he says, never had a mandate for the whole system, for financial stability – rather his job was to protect the PPF, which he did by locking down schemes one by one.
The question and challenge for policy makers now is do we continue with the model of locking down schemes (into LDI), disposing of growth assets (I refuse to accept the regulatory labelling of equity, enterprise, and infrastructure investment as “risk assets”), or, do they take ownership for the bigger picture and provide some policy direction for better ways to manage this £3trn of the nation’s stored wealth?
If we continue to invest in the scale currently envisaged in the dead capital of LDI, that will determine the prospects for our economy. The initial reactions to a few buyers refusing to meet the price for increasingly exotic tulips in 1637 were frantic attempts to ‘stabilise’ the market – “keep buying bulbs”. Economic growth – needed to fund a societal non-working wage for the elderly (pensions) on a macro-level – comes only from investment in new and better ideas, and success from the hard work in supporting the fundamentals of value, return and growth, and of having a sufficiently (but not overly) diversified basket of assets, including some gilts and bonds.