You will not know “Jnamdoc”, it is the pseudonym of a regular contributor to this blog. He has taken to writing comments on my blog which are often more interesting than the blog itself. I’d like to draw your attention to a comment on my blog yesterday asking whether LDI has done more good than harm, or vice versa. My blog focussed on the funding position of schemes , Jnamdoc, elevates the question to a different level – read on
It was of interest that when presented with an open goal at the WPC last week, Mr Fairs did not actually dispute the £500bn – rather he offered a meek retort along the lines of “well it depends when one measures such things, etc etc”.
Back to the central theme of this blog – it really starts with the maxim to prioritise pension-in-payments above all other calls on the economy, and playing on the fear of old age poverty.
The moral arguments runs along the lines that pensioners are less able to work to replace a loss in retirement, and so we look to ensure that (DB) pensioners have a fixed / secure source of income that grows with some measure of inflation.
Fair enough. This leads to the modelling assumption to use a fixed / secure source of assets to pay those pensions, which leads to gilts and LDI. LDI with Leveraged is borne of the TPR’s drive for schemes to seek sufficiently high funding levels so as to de-risk all pensions from reliance on the sponsoring employer, with can later be shifted to buy-out when sufficiently funded.
The leverage part (which creates a need to collateralise i.e. pledge pension scheme assets because banks do not take counter-party risk – they simply broker for a ‘modest’ margin between lender and borrower, if we accept use of the b word) came in with a well-intended notion to fund schemes as if, so as to be, buy-out-ready in terms of hedging against the main controllable risks as perceived by insurers – inflation and the liability measurement (using risk-free assets – gilts).
But as the cost of actual gilts was prohibitively high (because of QE, which also led to a scarcity of bonds), meaning hedging had to be accessed through synthetic gilts via derivatives and repos (i.e. for no initial cost, other than increased borrowing – the liability side of the swap). The effect of this was akin to accelerating the hedging part of the buy-out solution by at least a generation, some 10-15 years (the point of significant maturity in DB technical language). A sort of “hedge now/pay later” type arrangement.
The near catastrophic LDI fallout witnessed over the autumn was, just as Con Keating and Prof Iain Clacher have been trying to educate us these last couple of years, a natural consequence just waiting for timing and markets to crash into (or, out of the modelled but predictable) alignment. The leveraging of LDI simply multiplied and accelerated, bringing forward the consequences of over-borrowing (to use the b word again). You could tell it’s risky when the banks demand collateral!
But as noted at the start of this blog response, the genesis of this is the notion to fix or hypothecate a section of our (dynamic – meaning up or down) economic output, which became encapsulated in strong regulatory powers driving private sector DB schemes on a quest to de-risk (so members’ benefits were not ‘at risk’, a mortal sin)
To simplify, let’s consider a thought exercise at the extremes. If an entire population and economic capacity (so with no savings or investments) is comprised of 19 productive workers, and 1 non-working retired person, then the 19 can agree to support the retired person providing a fixed share from their collective output, and they can even agree to codify that into a set of rules. Roll-forward a number of years, till we have 1 productive worker and 19 retired persons.
Clearly at that extreme, something about the model has to change! The issue we are faced with now is understanding where along that demographic journey we are as an economy. Demographic and longevity changes mean that there are fewer productive workers proportionately to deliver the economic output needed to provide a non-working income for an increasing number of years to be enjoyed in retirement.
And the sheer enormous scale now of the DB savings pots give evidence to the proportion of current and future economic output we collectively have agreed to provide to the non-working elderly – the pension needs and share is a long way from the 1:19 ratio it may once have been.
The problem is routed in group-think, in not re-considering, not updating the thinking behind the model for different times, and sticking with the desire to hypothecate that allocation of income in a fixed or secure way – somewhere along our collective DB journey we rolled out the de-risking model to such an extent we forgot about and have lost the critical feedback loop (ie investment) into the economy that is so crucial for generating the income to pay the pensions.
This years’ Reith Lecture by Dr Fiona Hill is a brilliant essay and listen on the seductive and corrosive power of fear and how it can grip the psyche of a population (The Reith Lectures – The Four Freedoms – 4. Freedom from Fear – BBC Sounds). A most primal fear for us all is the fear of poverty and destitution and abandonment in old age.
And it is not an unreasonable step, indeed it is perfectly laudable aim, to want to provide for ourselves lessening the burden on others in our old age and to want to do that in the most secure or risk-free way possible, and so convinced we have been on the moral basis for this that we have even allowed introduced laws to criminalise those who (with judgemental hindsight) could be judged to have put at risk (using the double negative, who lessened the de-risking, or sought to invest) members’ benefits.
Taking from Dr Hill’s concluding comments in her December 2022 Reith Lecture, what is needed to overcome fear is courage, courage to invest in ourselves and in the younger generation, and having the belief they will create the wealth to support us in our old age.
At a fiscal and societally level we make tax rules giving tax benefits to encourage behaviours we consider will benefit the whole of society – that is the reason pension contributions are tax deductible and the income in the accumulation phase until retirement is also tax free – investing is ‘risky’ and somewhere in our history we were aware that investment by pension schemes should to be encouraged.
As I have commented in earlier blogs, the £3trn of DB savings should be treasured as a national store of wealth capable of being invested for the greater and common good, providing the drivers for economic growth we all need to pay a living wage for the elderly.