I’ve been wondering why I’m interested in LDI. It’s not out of academic interest – I don’t think academically and I’m not a practitioner. I have no skin in the game. But LDI interests me as someone who’s interested in how we turn pots into pensions, which is my central pre-occupation and why I set up AgeWage.
This blog is about the questions I keep asking myself, as a 61 year old with 30 years of life expectancy in front of him!
Why did we give up on true Liability Driven Investment?
It seems to me that the guarantees that are offered by defined benefit schemes aren’t greatly valued by those who get them. This is evidenced by the demand for DB transfers which swap guaranteed income for a set amount of cash paid into a personal pension.
Even the limited guarantees of inflation protection in corporate DB plans aren’t valued very much. Consultants soon worked out that swapping these increases for “sexy cash” (Steve Webb’s phrase) was a no-brainer for people for whom the impact of inflation was a thing of the past. So billions have been wiped off DB liabilities and very little scrutiny paid to whether “Pension Increase Exchange” was offering long-term value or turning DB pensions into a financial irrelevance over the decades most pensioners have in retirement.
The easiest way to “de-risk” a scheme’s liabilities is to incentivise people to give them up and that’s how those advising sponsoring employers on pensions – have occupied their time over the past 15 years. While sponsors craved the stability that LDI offered their corporate balance sheets, they embraced de-risking programs as their first step to buy-out.
The next stage to buy-out is to have all interest and inflation liabilities hedged. The full cost version of LDI offers the employer a high certainty of successfully offloading the pension scheme altogether. Like I say, nobody wants these guarantees. Liability Driven investment has not been embraced as a means to meet pension scheme liabilities but as a means to get rid of guarantees that companies never wanted to offer.
In retrospect, it was when – around the turn of the century, the political imperative – post Maxwell – was to write pension promises in stone, that DB pensions turned from an employee benefit to a “risk-management exercise”. True LDI saw its moment of greatness flicker with the Boots pension scheme, but that experiment was unwound within a couple of years , when the sponsor baulked at LDI’s expense to its P/L. Since then – true LDI has been practiced only by those with the deepest pockets, notably the Bank of England’s funded staff scheme – which sucks in over 50% of pensionable payroll as an ongoing funding rate. We have – for the most part – given up on “true LDI”.
Is Leveraged LDI – “costume jewelry”?
Instead of properly matching liabilities, the market moved on to something we might consider “costume” jewelry.
Costume jewelry has its value, it is not the real thing (like the BOE’s diamond pension scheme) but it allows schemes to scrub up well for the accountants and TPR can point to fewer schemes failing into the PPF than predicted and a healthy funding position of schemes right now (see graph at top).
Among both academics and fundamental de-riskers , Leveraged Liability Driven Investment (LLDI) is seen as doing more harm than good. John Ralfe , Con Keating and Iain Clacher can agree on that.
But on the other side of the argument are TPR, the consultants and the trustees who bought into leveraging their long dated gilts to buy more. This leverage was in line with other means of “de-risking”, indeed it incentivised transfers and increase exchanges because it drove down discount rates which pushed up transfer values. Throughout the last decade, the nominal discount rates in low single digits for most schemes, the “plus” in the gilts + formulation was created by borrowing against gilts using derivatives and repo.
This worked for as long as it worked and when it came to an end, there was a loud bang as sharp rise in yields burst the balloon. Was LLDI fake or did it offer a cheap way for schemes to dress up to their accounting responsibilities to a point that we can say – LLDI is still worth it?
I puzzle over that. I can see a number – £500bn – which is Clacher and Keating’s estimate of the damage of the balloon bursting in 2021. (This needn’t of course have happened, but it’s hard to deflate a balloon)
I don’t see any number which points to the benefit to schemes of LDI between -say 2010 and the start of 2022. I suspect this could be done by taking the asset mixes of schemes before embarking on LDI ( a proxy being those who don’t use LDI) and plotting their funding positions over the 12 years. What would have been the end point if 60% of schemes had not used LDI? What would have been the impact on sponsors ? Would there have been schemes having to join the PPF and would corporate failures have increased if LDI had not been in place?
We don’t have any academic research to show us the counter factual and without it, the benefit counterweighing the £500bn loss occasioned by the bursting of the balloon, can’t be assessed.
There are of course , other things to bear in mind. Schemes liabilities over the period 2010 to 2020 will have changed – their duration decreased as closed schemes don’t balance more people becoming pensioners by more people joining schemes as youngsters. Did the steady closure of schemes to new entrants and future accrual (which continues to this day), make LLDI essential, or was there another way?
Is there another way to LDI and LLDI?
I started this blog thinking about why I think about LDI and LLDI and hinting that it’s because I see another way of turning pots into pensions. That “other way” is of course to stop guaranteeing pensions and moving (back) to a system of best endeavours where a promise is only as good as the fund behind it. Which is essentially what CDC is.
Modelling tells us that the need for cuts in nominal pensions (assuming prudent pension promises and the buffer of conditional indexation) is very small. CDC pensions will rarely fall in payment but they could at any time. Most of the wins and losses will be measured by the level of increases CDC pensions can afford to pay over time.
If you release those offering pensions (however you organise them) from having to guarantee benefits, you dispense with the need for “de-risking”, you run with risk at steady state and you plan your scheme or fund to pay the pensions as they come due, without the need to link funding valuations to a “risk-free” rate.
My interest in LDI and LLDI is in trying to understand the advantages of both. I am concluding that neither is offering much advantage as both are trying to solve a problem that need not be there.
If most people are happy to live without guaranteed second tier pensions (and most people seem to be happy – even without a DB plan) then we should be focussing on ways of turning these DC pots into pensions and running DB plans on a best endeavours basis. That may be the world I live in when I’m in my 70s and 80s.
What if DB had stayed as CDC?
What if we had decided to dispense with guarantees altogether and not closed all those DB schemes? What if our DB system had continued to invest in the open scheme sweet spot paying pensions with asset income and adjusting pensions according to the success of “best endeavours”?
I suspect that the real cause of harm for DB pension schemes in the past thirty years, is that they have shackled themselves to guarantees that they should have not taken on. Only those schemes guaranteed by the tax-payer (the public sector unfunded schemes) can really offer such guarantees (and the cost of those guarantees is at the cost of personal and corporate taxation).
If we work in the private sector, we have a different employer covenant – both at work and looking beyond work. I suspect that if we took the long view, we would answer the question in this blog’s title –
“both LDI and LLDI are ultimately harmful to pensions and to those who fund them”.