The FT comment suggests that gilt rates are a political commentary from the financial markets. I learn at the start of this long weekend that we could be less likely for increases in rate rises because a man who is not yet an MP has spoken as the market wants him to.
Gilts have had their best week in two and a half years after Labour leadership frontrunner Andy Burnham pledged to stick to the UK’s fiscal rules and traders pulled back from bets on higher Bank of England interest rates.
People who cashed in their “pensions” a week ago will get a markedly lower payment from their pots than those who cash in next week, because most of us who are of an age to draw our money (most of us into our bank account) get a pay-out based on what the bond markets are paying.
I am not talking here about those who are advised and have wealth, I’m talking about the majority of savers who no longer associate their pension with an income but think of it as a “nest egg” which pays out to pay off a mortgage , meet the cost of the daughter’s wedding or pay the bills for the parents who are in private care. If I don’t understand why the pay outs vary from week to week, then how do we expect everyone else. Most people do not spend their time trying to learn how the bond market works.
Coincidentally, the ace-blogger of the FT, Stuart Kirk has an article that tops the reading list in the paper
Which is some comfort to my feeble mind. He explains that “simple” things that we can do by analysing gilts, such as extracting the implied inflation predictions of the market, are far too simple. I have been taught about this simple things by my friendly actuary, Chris Bunford as a way of pricing the purchase of CDC pension from day to day. “Long-term”? I find the volatility of the value of bonds, of the yield of their interest and the implications of these numbers to the cost of buying a pension anything but simple – but it is too simple (according to Stuart who gives me five things to consider before I understand bonds).
I’ll refer to his article and first the frightening volatility of bonds (I imagine he wrote this piece before the recovery of last week!). He starts with the explanations that are given about global economics and British politics.
The nuts and bolts of bond pricing are Chinese algebra in comparison. It’s beyond me. But I can see the simple mistakes other ignoramuses make. And five have popped up repeatedly as the bond rout intensified.
I will try and pick out the meat from the bones of this argument so we can understand what we cannot really understand. The five errors that we make are list
- that bond markets are omniscient or at least smarter than equity markets
- related to this is the error of comparing bond yields with earnings yields.
- that rising 30-year yields are due to bond investors losing faith in cash-strapped nations being able to reduce their sizeable debt-to-output ratios.
- to my conversation with my actuary, only surveys reveal what investors think inflation a decade down the road will be.
- the long list of complex factors that influence bond prices is also why inflation-linked bonds are not a substitute for measuring real yields. Conflating the two is the fifth misconception
I’m a humble fellow who has never tried to be an actuary or even try to understand what actuaries know, but I find myself in a job that gets me to explain to ordinary people why the pensions they get going forward will be invested not in corporate bonds and gilts but real assets like shares and infrastructure that over time deliver more than bonds. I was taught that in 1983 and though I’ve never understood it, it has done me well, I am still invested for my retirement in shares and not in bonds.
I have friends such as Con Keating who spent his life trading bonds and did very well out of understanding where the market got it wrong and betting against it. This is fine for a brain like his but he has given up trying to teach me how bonds work. I am glad that I am in the company of Stuart Kirk and more actuaries than would care to admit it. Bonds are bloody hard and should not be used to pay pensions if you’re open to new money and not in an end-game.
Here in the “sweet spot” of a DB or CDC fund benefits should be paid from the income of growth assets because the scheme has an infinite time horizon. The market value of a scheme’s assets is irrelevant. What matters is the increasing income over time which pays us an inflation linked wage for life. That I can understand which is why I want to be bold, be invested in growth assets and not bonds and take a very long view.
In this I am onside with some DC proprietors, Patrick being one of them. I hope he will come across to CDC with People’s Partnership! He must be as sick as me with the complexity of bonds and trying to understand them!
Alchemy??
Do you understand the IPO?
“ SpaceX is using a dual-class share structure that gives Musk near total control. Class B shares get ten votes each, and lowly Class A shareholders get just one. After the IPO, Musk is expected to control around 80% of the voting power despite a much smaller ownership share. He will likely become the world’s first trillionaire in the process.
Musk can only be removed as chair or CEO by a majority vote of the class B shareholders, in effect guaranteeing his position in perpetuity.
The SpaceX board recently granted him 1.3 billion class B shares, with the award vesting in tranches as the company meets valuation milestones and technical achievements. To get the maximum payout, Musk needs to get AI data centres orbiting Earth and establish a permanent colony on Mars with at least 1 million inhabitants.”
I don’t understand this at all , John!
Can you explain why, not how, someone with a small pension pot can see their amount of benefits go up or down substantially because of the performance of bonds that day?
Most savers have no idea what they are in and see “fixed interest” as safe. They do not get warned that corporate bonds and gilts can – when cashed – be worth a lot more or less than you expected. Your expectation is what you see on your pension portal, what you get is what you get in your bank and people don’t get told any of this. It’s scandalous Gareth. There is no reason “why” people cashing in their pensions need to be in bonds and many of them would be better with their pot paying them a pension. I know that there are some who are better out of pensions because of pension credit but I don’t think we can build a national pension strategy around an anomaly.
It is the market price of bonds, and gilts in particular, that has the greatest market price volatility both long term and short term of any of the asset classes used to fund future pension benefits – whether in a pre-retirement DC pot or a DB and potentially a CDC fund. However once purchased they do provide a (reasonably) secure income stream for the duration of the bond.
So for example in my (drawdown) SIPP I am directly holding a 30 year gilt – which is giving me an annual interest payment of 5.5% of the current market value and a redemption payment in 30 years time of 103% of the current market value. Both of these are unaffected by the 2.1% fall in the market value of the holding since I purchased the gilt. As 30 years covers my expected lifespan on the most optimistic assumption, the market value volatility is entirely irrelevant to me. Other bond type investments have similar characteristics but normally of much shorter duration meaning that the redemption proceeds against the purchase price become much more significant to the bond holder.
However my pension income from my gilt holding does not protect me from inflation, particularly in the final years of my life when care costs are likely to dominate my expenditure and historically and predictably increase faster than general inflation. I also have to consider the risk prospects over 30 years e.g. the possibility of a “haircut” to my gilt interest or redemption payments to me or my beneficiaries. I therefore hold other asset classes designed to provide growth both in income streams (e.g. equity dividends) or in capital value when realised (e.g. an accumulation fund).
Inflation linked gilts are effectively no use because of the minimal coupon rate annual interest. with effectively only the redemption proceeds reflecting inflation. This means that only if you intend to sell the investment or hold to maturity do you obtain any benefit from the index linking. They are no use in providing regular income to match pension payments. While the market value and hence the yield is tied to the volatile fixed interest gilts, it does concern me that the inflation premium applied over a fixed interest gilt of the same duration is used as the inflation assumption for future pension benefits in the valuation of pension schemes’ liabilities where the market price is effectively determined by the same pension schemes. Effectively pension schemes collectively control their own future inflation assumption. To me another clear systemic risk in using market determined assumptions.
Much the same arguments concerning my SIPP should apply to a pension fund, except that the secured income flows from the existing investments are effectively ignored in a valuation and substituted by a comparison of the current total market value to the current to the current gilt yield (of a different duration). This results in a non entirely matched gilt portfolio having even greater volatility in (the assumed) surpluses or deficits than even the highly volatile gilt yield. is this appropriately being considered in current surplus estimations and of particular concern is currently assumed surpluses are being distributed out of the pension fund either to employers or by way of an additional payment to members.
The other problem that both pension schemes and individual’s face is the purchasing and holding investments directly without the loss to investment management charges. My SIPP is held with an interactive execution only provider with a fixed annual management charge (well below 0.05% of the AUM). However pension funds are encouraged to hold their investments by asset managers and their retailer investment consultants in managed funds with management charges based on value of assets under management and hence tied to market values even when these are irrelevant. Why do you need an asset manager to receive bi-annual interest payments when they could be paid directly into the Trustee’s bank account? Why do you need a custodian when the Trustee’s can be recorded on the Government’s share register? It appears that this is another form of discrimination against the smaller pension scheme to the benefit of the pension industry!
I see a lot of articles about DIY gilt based step ladders and i can see value over annuities for those who have the financial sophistication to do the work to make these work. Isn’t the truth that bundled products like annuity , the new guided retirement defaults and CDC are for the vast majority of people who can’t take these decisions? Here I think people need to understand the decisions taken by their employers and by the trustees of the plans they are put in.
There are simple rules around annuities, flex and fix and CDC as well as DIY Sipps. They need to available for non-pension people to compare
Bonds are complicated if actively traded but very simple if purchased and held to maturity without ever trading them in between. Even simpler if purchased in the primary market at issuance.
They’re called ‘fixed income’ for a reason. At purchase, you know the price you’re paying and the exact coupons you’ll receive (hence you know your yield to maturity) and when you’ll receive them, and you know the exact amount you’ll receive back on maturity.
You know all of the cash flows arising from your ownership (caveat: so long as there’s no default, natch). What could be simpler?!
Ah, but what about inflation? It’s all very well knowing your coupon payments and par value paid on maturity, but these are nominal amounts not real. So buy TIPS or linkers instead.
In contrast, with equities you have no idea what future cash flows you’ll receive, just educated guesswork and an open ended “hope for the best”. Will anyone ever understand equities?!
OK – the above is me playing devil’s advocate a little, but true in principle if incomplete in practice. Fixed income — bonds — are simple in principle because their cash flows are contractually fixed, but these payments make bonds complex in practice, especially if trading them, because precise calculations can be applied to them.