Investing for DB pension schemes

[ChrisNix]

OK my take on this is that pension funds have found this brilliant(!) new way to make up shortfalls in their funding or, to put it another way, to claim that they are fully funded, they just borrow by buying gilts via derivatives. In a nice calm everyday market, they need to put up a margin, call it an insurance premium , of something like say 3% of the total trade value. They pay that 3% in cash (£3,000) and can buy £100,000 of gilts to fund the 'gap'.

Then along came the mini budget and suddenly people began to question where the money was coming from, well, Government borrowing of course. That was perceived by the markets as likely to downgrade the UK's credit standing and so gilt borrowing rates were going to have to rise and derivative traders wanted instead of say 3% margin, something like say 6% ( I am making up these rates) That meant the derivative traders require cash paid on the nail representing a further 3% of the trade and most pension funds did not have these sorts of funds available as 'dry powder' as some have called it, so they had no option but to sell some assets and fast. That of course drove prices even lower and so on. A fullblown liquidity crisis.

Cue the BoE to step in and buy these gilts which were being offered by the pension funds in the fire sale.

That is probably not right or I have missed something but that is as I understand it.

Dod

Margin doesn't work like that.

A Derivative contract will be entered with typically no cost. Often there is no initial margin, but sometimes there is, and the contract's movement in price will drive the required cash (or collateral) payments.

Consider a bet on a football match on the number of goals. An average game has 2 goals. You and I decide to have a bet and you want to be paid out on the number of goals risking £100 a goal, expecting more than 2. Depending on whether an initial margin is required you might pay me a small amount say 1/2 a goal up front. Given it is low risk though and we are both "good" counterparties with excellent credit ratings I may agree I don't need any margin. The maximum you will owe me is a 0-0 draw meaning I need £200.

At kick-off the score is 0-0 and the longer the game goes on without a goal the more likely it will be you owe me money at the end of the game, so the expected goals falls (as time runs out). If the game was being margined I would expect every couple of minutes you to have to pay me £1 to compensate me for the risk you are likely to owe me £200 in 90 minutes (or now less). Similarly if a goal was scored I would (rapidly) pay you £100 ish as the value of the bet moves, in this case dramatically. If at half time the score was 4-2 you would be guaranteed at least £400 (6 less the bets strike of 2), so would in a margined world at least expect to receive £400 from me (probably more). This continues through the 90 minutes until the bet finishes when instead of me paying the full amount of £900 (the final score being 6-5 !!) I will only pay a small residue since the margin calls every minute had delivered the winnings to you over the life of the game.

Now consider the same process, but not over 90 minutes, but over 30 years, and one where the score can go both ways. Noone would enter into a 30 year contract without a margin to adjust for the current market price (or match score). Who knows if you will be alive in 30 years, or what your financial health will be to honour that bet. Margin is normal.

Now consider a short period in time in that 30 year bet, such as a day or so when our bet which is effectively the change in price from expected of a price of a gIlt moves dramatically. The Gilts expected price is say £150 in 30 years, but with (future) interest rates repriced to the market to say £50 the margin call is huge. If I had taken the bet in the football analogy (cricket runs is probably a better example!) when in the first minute 5 goals were scored I would face a massive and unexpected margin call.

Most DB pension funds though would be profit up on the markets move. They are under hedged. The value of their liabilities (the current discounted valuation of all their expected pension payments) has fallen significantly more than the fall in values of the assets (Gilts and LDI contracts). Their immediate cash needs are (massively) increased though. The pension payments are in the future - so don't affect cash now. the margin calls are immediate though. How to raise immediate cash? Sell assets, even with regret, at bad prices in the most liquid markets.

I realise this is all beyond my understanding, but why is the BoE giving such a short deadline to pension funds to sort themselves out byFriday? What could they ‘sort out’ over such a short time frame? If the BoE wants to stabilise things it must say ‘whatever it takes, for however long’, surely?

It seems the Bank of England has concerns that pension schemes were dragging their feet rather than realising assets to pay margins and generate dry powder, and/or reducing their LDI bets.

The problem is that if global long term rates rise another 1% there is plenty more still to come.

https://www.reuters.com/world/uk/britis ... 022-10-12/

[Dod101]

OK my take on this is that pension funds have found this brilliant(!) new way to make up shortfalls in their funding or, to put it another way, to claim that they are fully funded, they just borrow by buying gilts via derivatives. In a nice calm everyday market, they need to put up a margin, call it an insurance premium , of something like say 3% of the total trade value. They pay that 3% in cash (£3,000) and can buy £100,000 of gilts to fund the 'gap'.

Then along came the mini budget and suddenly people began to question where the money was coming from, well, Government borrowing of course. That was perceived by the markets as likely to downgrade the UK's credit standing and so gilt borrowing rates were going to have to rise and derivative traders wanted instead of say 3% margin, something like say 6% ( I am making up these rates) That meant the derivative traders require cash paid on the nail representing a further 3% of the trade and most pension funds did not have these sorts of funds available as 'dry powder' as some have called it, so they had no option but to sell some assets and fast. That of course drove prices even lower and so on. A fullblown liquidity crisis.

Cue the BoE to step in and buy these gilts which were being offered by the pension funds in the fire sale.

That is probably not right or I have missed something but that is as I understand it.

Dod

Margin doesn't work like that.

A Derivative contract will be entered with typically no cost. Often there is no initial margin, but sometimes there is, and the contract's movement in price will drive the required cash (or collateral) payments.

Consider a bet on a football match on the number of goals. An average game has 2 goals. You and I decide to have a bet and you want to be paid out on the number of goals risking £100 a goal, expecting more than 2. Depending on whether an initial margin is required you might pay me a small amount say 1/2 a goal up front. Given it is low risk though and we are both "good" counterparties with excellent credit ratings I may agree I don't need any margin. The maximum you will owe me is a 0-0 draw meaning I need £200.

At kick-off the score is 0-0 and the longer the game goes on without a goal the more likely it will be you owe me money at the end of the game, so the expected goals falls (as time runs out). If the game was being margined I would expect every couple of minutes you to have to pay me £1 to compensate me for the risk you are likely to owe me £200 in 90 minutes (or now less). Similarly if a goal was scored I would (rapidly) pay you £100 ish as the value of the bet moves, in this case dramatically. If at half time the score was 4-2 you would be guaranteed at least £400 (6 less the bets strike of 2), so would in a margined world at least expect to receive £400 from me (probably more). This continues through the 90 minutes until the bet finishes when instead of me paying the full amount of £900 (the final score being 6-5 !!) I will only pay a small residue since the margin calls every minute had delivered the winnings to you over the life of the game.

Now consider the same process, but not over 90 minutes, but over 30 years, and one where the score can go both ways. Noone would enter into a 30 year contract without a margin to adjust for the current market price (or match score). Who knows if you will be alive in 30 years, or what your financial health will be to honour that bet. Margin is normal.

Now consider a short period in time in that 30 year bet, such as a day or so when our bet which is effectively the change in price from expected of a price of a gIlt moves dramatically. The Gilts expected price is say £150 in 30 years, but with (future) interest rates repriced to the market to say £50 the margin call is huge. If I had taken the bet in the football analogy (cricket runs is probably a better example!) when in the first minute 5 goals were scored I would face a massive and unexpected margin call.

Most DB pension funds though would be profit up on the markets move. They are under hedged. The value of their liabilities (the current discounted valuation of all their expected pension payments) has fallen significantly more than the fall in values of the assets (Gilts and LDI contracts). Their immediate cash needs are (massively) increased though. The pension payments are in the future - so don't affect cash now. the margin calls are immediate though. How to raise immediate cash? Sell assets, even with regret, at bad prices in the most liquid markets.

I have read that with interest. Many thanks. I do not pretend to understand hedging and margins but these comments have helped.

Dod

[micrographia]

After reading the patient explanation from dealtn and the statement from USS (link below) my understanding of the situation is much better. Many thanks all - TLF at its best.

Another data point for interested observers; as a DB scheme still open to new members USS hold more growth assets than closed funds and have therefore been unaffected by the liquidity issue. As interest rates rise it anticipates being "...in an increasingly good position going forward." They have in fact been buying gilts while they are on sale. It's an interesting short read. You can't help wondering which funds are still under the cosh and which employers might be needed to provide a cash injection if positions haven't been unwound by close tomorrow though.

https://www.uss.co.uk/news-and-views/la ... strategies

Regards, EEM.

[Dod101]

After reading the patient explanation from dealtn and the statement from USS (link below) my understanding of the situation is much better. Many thanks all - TLF at its best.

Another data point for interested observers; as a DB scheme still open to new members USS hold more growth assets than closed funds and have therefore been unaffected by the liquidity issue. As interest rates rise it anticipates being "...in an increasingly good position going forward." They have in fact been buying gilts while they are on sale. It's an interesting short read. You can't help wondering which funds are still under the cosh and which employers might be needed to provide a cash injection if positions haven't been unwound by close tomorrow though.

https://www.uss.co.uk/news-and-views/la ... strategies

Regards, EEM.

From an asset point of view, I cannot see any DB pension scheme needing a cash injection. After all we have lived with underfunding in DB pension schemes for years. Liquidity is another matter.

The interesting thing to me is what is the BoE trying to do? I suppose to put pressure on the Government to reverse some of the tax cuts in the mini budget, because they at least in the short term run exactly contrary to what the BoE is trying to do, reduce inflation, which is their primary remit. It will be interesting to see what happens.

Dod

[scrumpyjack]

After reading the patient explanation from dealtn and the statement from USS (link below) my understanding of the situation is much better. Many thanks all - TLF at its best.

Another data point for interested observers; as a DB scheme still open to new members USS hold more growth assets than closed funds and have therefore been unaffected by the liquidity issue. As interest rates rise it anticipates being "...in an increasingly good position going forward." They have in fact been buying gilts while they are on sale. It's an interesting short read. You can't help wondering which funds are still under the cosh and which employers might be needed to provide a cash injection if positions haven't been unwound by close tomorrow though.

https://www.uss.co.uk/news-and-views/la ... strategies

Regards, EEM.

In theory higher interest rates are 'good' for a pension fund because future liabilities are discounted at a higher rate but surely this involves bold assumptions about future inflation rates and if inflation is going to be even higher than the increased interest rates then the net result surely is that the pension fund is worse off because the future liabilities are increasing even more than the rate at which they can be discounted. There are massive risks, which really cannot be quantified accurately, for these DB schemes, and whoever is underwriting them. Fiddling with LDIs can't mitigate those long term risks much?

[Alaric]

[
In theory higher interest rates are 'good' for a pension fund because future liabilities are discounted at a higher rate but surely this involves bold assumptions about future inflation rates and if inflation is going to be even higher than the increased interest rates then the net result surely is that the pension fund is worse off because the future liabilities are increasing even more than the rate at which they can be discounted. There are massive risks, which really cannot be quantified accurately, for these DB schemes, and whoever is underwriting them. Fiddling with LDIs can't mitigate those long term risks much?

That's why pension funds are big buyers of indexed Gilts, no matter how low the yield. There's also a hidden source of profit, since whilst Indexed securities revalue the maturity and coupon values at RPI or CPI, many schemes cap the RPI or CPI increases at a lower rate, 3% or 5%.

[ChrisNix]

[
In theory higher interest rates are 'good' for a pension fund because future liabilities are discounted at a higher rate but surely this involves bold assumptions about future inflation rates and if inflation is going to be even higher than the increased interest rates then the net result surely is that the pension fund is worse off because the future liabilities are increasing even more than the rate at which they can be discounted. There are massive risks, which really cannot be quantified accurately, for these DB schemes, and whoever is underwriting them. Fiddling with LDIs can't mitigate those long term risks much?

That's why pension funds are big buyers of indexed Gilts, no matter how low the yield. There's also a hidden source of profit, since whilst Indexed securities revalue the maturity and coupon values at RPI or CPI, many schemes cap the RPI or CPI increases at a lower rate, 3% or 5%.

That's perhaps missing the fact that buying on a negative 2.5% real yield only adds value if inflation turns out to be 2.5% or more. Fine now, but not in past few years.

And one needs to hold to maturity, because the yield shift has slashed the resale value of long linkers. The 2073 issue was down 85% plus over past year!

[dealtn]

[
In theory higher interest rates are 'good' for a pension fund because future liabilities are discounted at a higher rate but surely this involves bold assumptions about future inflation rates and if inflation is going to be even higher than the increased interest rates then the net result surely is that the pension fund is worse off because the future liabilities are increasing even more than the rate at which they can be discounted. There are massive risks, which really cannot be quantified accurately, for these DB schemes, and whoever is underwriting them. Fiddling with LDIs can't mitigate those long term risks much?

That's why pension funds are big buyers of indexed Gilts, no matter how low the yield. There's also a hidden source of profit, since whilst Indexed securities revalue the maturity and coupon values at RPI or CPI, many schemes cap the RPI or CPI increases at a lower rate, 3% or 5%.

That's perhaps missing the fact that buying on a negative 2.5% real yield only adds value if inflation turns out to be 2.5% or more.

No. That's only if you look at a long index linked gilt holding in isolation. Owning them as an inflation hedge strategy isn't complete - its not what they are. Long Index linked Gilts gives you a long inflation position but also a long bond position. if you don't need an interest rate position (and most Pension Funds do) and only want an inflation position you need to sell gilts against it (or hold an inflation swap or other derivative instead!).

They are plenty of scenarios where buying a linker, even with a negative real yield, adds (some) value, but they involve other positions in combination too.

[ChrisNix]

[
In theory higher interest rates are 'good' for a pension fund because future liabilities are discounted at a higher rate but surely this involves bold assumptions about future inflation rates and if inflation is going to be even higher than the increased interest rates then the net result surely is that the pension fund is worse off because the future liabilities are increasing even more than the rate at which they can be discounted. There are massive risks, which really cannot be quantified accurately, for these DB schemes, and whoever is underwriting them. Fiddling with LDIs can't mitigate those long term risks much?

That's why pension funds are big buyers of indexed Gilts, no matter how low the yield. There's also a hidden source of profit, since whilst Indexed securities revalue the maturity and coupon values at RPI or CPI, many schemes cap the RPI or CPI increases at a lower rate, 3% or 5%.

That's perhaps missing the fact that buying on a negative 2.5% real yield only adds value if inflation turns out to be 2.5% or more.

No. That's only if you look at a long index linked gilt holding in isolation. Owning them as an inflation hedge strategy isn't complete - its not what they are. Long Index linked Gilts gives you a long inflation position but also a long bond position. if you don't need an interest rate position (and most Pension Funds do) and only want an inflation position you need to sell gilts against it (or hold an inflation swap or other derivative instead!).

They are plenty of scenarios where buying a linker, even with a negative real yield, adds (some) value, but they involve other positions in combination too.

You can take the long bond element out but the point remains that linkers are not a good inflation hedge for DB schemes 'no matter how low the yield'.

A better attitude for a scheme when rates were negative 2.5% -- if it had bought linkers at say a 1% positive real yield -- would have been to bank the (very considerable) profit, given the hedging was down to the slice between 2.5% and 5%. Funding improved and better things to reinvest in.

Very few consultants evidence comprehension of this.

[dealtn]

[
In theory higher interest rates are 'good' for a pension fund because future liabilities are discounted at a higher rate but surely this involves bold assumptions about future inflation rates and if inflation is going to be even higher than the increased interest rates then the net result surely is that the pension fund is worse off because the future liabilities are increasing even more than the rate at which they can be discounted. There are massive risks, which really cannot be quantified accurately, for these DB schemes, and whoever is underwriting them. Fiddling with LDIs can't mitigate those long term risks much?

That's why pension funds are big buyers of indexed Gilts, no matter how low the yield. There's also a hidden source of profit, since whilst Indexed securities revalue the maturity and coupon values at RPI or CPI, many schemes cap the RPI or CPI increases at a lower rate, 3% or 5%.

That's perhaps missing the fact that buying on a negative 2.5% real yield only adds value if inflation turns out to be 2.5% or more.

No. That's only if you look at a long index linked gilt holding in isolation. Owning them as an inflation hedge strategy isn't complete - its not what they are. Long Index linked Gilts gives you a long inflation position but also a long bond position. if you don't need an interest rate position (and most Pension Funds do) and only want an inflation position you need to sell gilts against it (or hold an inflation swap or other derivative instead!).

They are plenty of scenarios where buying a linker, even with a negative real yield, adds (some) value, but they involve other positions in combination too.

You can take the long bond element out but the point remains that linkers are not a good inflation hedge for DB schemes 'no matter how low the yield'.

Not true.

If you buy at a low yield of neg 1%, sell gilts and make a very good inflation hedge if inflation averaged 10% (better than most LDI inflation derivative alternatives.

A better attitude for a scheme when rates were negative 2.5% -- if it had bought linkers at say a 1% positive real yield -- would have been to bank the (very considerable) profit, given the hedging was down to the slice between 2.5% and 5%. Funding improved and better things to reinvest in.

Very few consultants evidence comprehension of this.

And if they took profits on the 3.5% move from +1 to -2.5% and it moved to -6%? What better things would they have invested in than hold the original linkers?

Its easy in hindsight to say what should have been done. Even then you suggestion would have gone against the mandates the trustees give the managers. How would that have worked in practice - especially if your sell off didn't happen?

[ChrisNix]

That's why pension funds are big buyers of indexed Gilts, no matter how low the yield. There's also a hidden source of profit, since whilst Indexed securities revalue the maturity and coupon values at RPI or CPI, many schemes cap the RPI or CPI increases at a lower rate, 3% or 5%.

That's perhaps missing the fact that buying on a negative 2.5% real yield only adds value if inflation turns out to be 2.5% or more.

No. That's only if you look at a long index linked gilt holding in isolation. Owning them as an inflation hedge strategy isn't complete - its not what they are. Long Index linked Gilts gives you a long inflation position but also a long bond position. if you don't need an interest rate position (and most Pension Funds do) and only want an inflation position you need to sell gilts against it (or hold an inflation swap or other derivative instead!).

They are plenty of scenarios where buying a linker, even with a negative real yield, adds (some) value, but they involve other positions in combination too.

You can take the long bond element out but the point remains that linkers are not a good inflation hedge for DB schemes 'no matter how low the yield'.

Not true.

If you buy at a low yield of neg 1%, sell gilts and make a very good inflation hedge if inflation averaged 10% (better than most LDI inflation derivative alternatives.

A better attitude for a scheme when rates were negative 2.5% -- if it had bought linkers at say a 1% positive real yield -- would have been to bank the (very considerable) profit, given the hedging was down to the slice between 2.5% and 5%. Funding improved and better things to reinvest in.

Very few consultants evidence comprehension of this.

And if they took profits on the 3.5% move from +1 to -2.5% and it moved to -6%? What better things would they have invested in than hold the original linkers?

Its easy in hindsight to say what should have been done. Even then you suggestion would have gone against the mandates the trustees give the managers. How would that have worked in practice - especially if your sell off didn't happen?

I think you're too close to the wood to see the trees.

The issue is that at minus 2.5% real the only way things are going 'lower' is the greater fool [LDI zealot?] theory.

It's not hindsight, just obvious that financial repression at some point would uncoil and some of the anomalies would unwind. Oh and BTW when such events occur the moves can be 'extreme'. Now there's a surprise.

Going against the mandate excuse is a cop out. Not sure you've had experience actually running a scheme, but funding outlows isn't something which LDI style investment is particularly suited for.

It would appear that to its adherants LDI mandates are like Hotel California!

[dealtn]

That's perhaps missing the fact that buying on a negative 2.5% real yield only adds value if inflation turns out to be 2.5% or more.

No. That's only if you look at a long index linked gilt holding in isolation. Owning them as an inflation hedge strategy isn't complete - its not what they are. Long Index linked Gilts gives you a long inflation position but also a long bond position. if you don't need an interest rate position (and most Pension Funds do) and only want an inflation position you need to sell gilts against it (or hold an inflation swap or other derivative instead!).

They are plenty of scenarios where buying a linker, even with a negative real yield, adds (some) value, but they involve other positions in combination too.

You can take the long bond element out but the point remains that linkers are not a good inflation hedge for DB schemes 'no matter how low the yield'.

Not true.

If you buy at a low yield of neg 1%, sell gilts and make a very good inflation hedge if inflation averaged 10% (better than most LDI inflation derivative alternatives.

A better attitude for a scheme when rates were negative 2.5% -- if it had bought linkers at say a 1% positive real yield -- would have been to bank the (very considerable) profit, given the hedging was down to the slice between 2.5% and 5%. Funding improved and better things to reinvest in.

Very few consultants evidence comprehension of this.

And if they took profits on the 3.5% move from +1 to -2.5% and it moved to -6%? What better things would they have invested in than hold the original linkers?

Its easy in hindsight to say what should have been done. Even then you suggestion would have gone against the mandates the trustees give the managers. How would that have worked in practice - especially if your sell off didn't happen?

I think you're too close to the wood to see the trees.

The issue is that at minus 2.5% real the only way things are going 'lower' is the greater fool [LDI zealot?] theory.

It's not hindsight, just obvious that financial repression at some point would uncoil and some of the anomalies would unwind. Oh and BTW when such events occur the moves can be 'extreme'. Now there's a surprise.

Going against the mandate excuse is a cop out. Not sure you've had experience actually running a scheme, but funding outlows isn't something which LDI style investment is particularly suited for.

It would appear that to its adherants LDI mandates are like Hotel California!

I think you believe I am an apologist for Pension Fund Managers or the LDI industry. You couldn't be further from the truth. I have been calling this situation out (and with my own money) over the last 10+ years.

At least they understand the products, and the practicalities of their mandates.

I will call out those that speak untruths regardless of which side of an argument they are on, or what positions they hold. I can spot both wood and trees, and the difference between them. I think you are looking in hindsight at what is obvious now. I hope your obvious superior investing powers were backed up with a suitable, extremely profitable, investment position.

[ChrisNix]

No. That's only if you look at a long index linked gilt holding in isolation. Owning them as an inflation hedge strategy isn't complete - its not what they are. Long Index linked Gilts gives you a long inflation position but also a long bond position. if you don't need an interest rate position (and most Pension Funds do) and only want an inflation position you need to sell gilts against it (or hold an inflation swap or other derivative instead!).

They are plenty of scenarios where buying a linker, even with a negative real yield, adds (some) value, but they involve other positions in combination too.

You can take the long bond element out but the point remains that linkers are not a good inflation hedge for DB schemes 'no matter how low the yield'.

Not true.

If you buy at a low yield of neg 1%, sell gilts and make a very good inflation hedge if inflation averaged 10% (better than most LDI inflation derivative alternatives.

A better attitude for a scheme when rates were negative 2.5% -- if it had bought linkers at say a 1% positive real yield -- would have been to bank the (very considerable) profit, given the hedging was down to the slice between 2.5% and 5%. Funding improved and better things to reinvest in.

Very few consultants evidence comprehension of this.

And if they took profits on the 3.5% move from +1 to -2.5% and it moved to -6%? What better things would they have invested in than hold the original linkers?

Its easy in hindsight to say what should have been done. Even then you suggestion would have gone against the mandates the trustees give the managers. How would that have worked in practice - especially if your sell off didn't happen?

I think you're too close to the wood to see the trees.

The issue is that at minus 2.5% real the only way things are going 'lower' is the greater fool [LDI zealot?] theory.

It's not hindsight, just obvious that financial repression at some point would uncoil and some of the anomalies would unwind. Oh and BTW when such events occur the moves can be 'extreme'. Now there's a surprise.

Going against the mandate excuse is a cop out. Not sure you've had experience actually running a scheme, but funding outlows isn't something which LDI style investment is particularly suited for.

It would appear that to its adherants LDI mandates are like Hotel California!

I think you believe I am an apologist for Pension Fund Managers or the LDI industry. You couldn't be further from the truth. I have been calling this situation out (and with my own money) over the last 10+ years.

Apologies if I mischaracterised you. What exactly is the situation you say you've been calling out?

At least they understand the products, and the practicalities of their mandates.

I expect at some level they do. But most of the trustees I worked with would have struggled to have grasped what could go wrong with LDIs and probably didn't understand the difference between matching a hypothetical construct of the present value of scheme liabilities and funding the benefit outflows themselves.

I will call out those that speak untruths regardless of which side of an argument they are on, or what positions they hold. I can spot both wood and trees, and the difference between them. I think you are looking in hindsight at what is obvious now. I hope your obvious superior investing powers were backed up with a suitable, extremely profitable, investment position.

Sorry, but you'll have to take my word that this isn't hindsight. Mind you things persisted quite a long time longer than I expected, and maybe it took Covid to set in train the events which have led to where we are. Do you factor regresson to the mean into your investing?

My investment fund has been VERY profitable over the last few years: thanks for asking.

[dealtn]

Apologies if I mischaracterised you. What exactly is the situation you say you've been calling out?

Your incorrect usage of the quote system (and not including my user name to alert me to your questions) make this a difficult post to reply to. So I will limit it to this question. its impossible to do so exactly but to summarise I have been calling out all those that proclaim "derisking" when in reality the best they have been doing is reducing risks, or swapping one set of risks for another.

If I was a meaner type of person I would be enjoying the schadenfreude of those now licking wounds they chose not to believe possible. The worst of which thought they had a riskless hedged outcome.

Of course many of those have also had good outcomes, despite their ignorance.

Of course many of those that see and shout about the "obvious" inadequacies of some investors, such as DB Pension scheme managers also don't understand that many of those obvious losers are in fact winners, even if some of that fortune wasn't planned. Most underhedged schemes now have the opportunity to increase their hedging at far more attractive levels than previously thought possible - despite the disastrous losses on (a selective sample of some of) their assets. Many have also benefitted from inflation hedge outcomes far superior to the increase in their inflation liabilities since Index Linked Gilts strategies will see returns greater than the capped growth of their future inflation driven pension expenditures.

[ChrisNix]

Apologies if I mischaracterised you. What exactly is the situation you say you've been calling out?

Your incorrect usage of the quote system (and not including my user name to alert me to your questions) make this a difficult post to reply to. So I will limit it to this question. its impossible to do so exactly but to summarise I have been calling out all those that proclaim "derisking" when in reality the best they have been doing is reducing risks, or swapping one set of risks for another.

If I was a meaner type of person I would be enjoying the schadenfreude of those now licking wounds they chose not to believe possible. The worst of which thought they had a riskless hedged outcome.

Of course many of those have also had good outcomes, despite their ignorance.

Of course many of those that see and shout about the "obvious" inadequacies of some investors, such as DB Pension scheme managers also don't understand that many of those obvious losers are in fact winners, even if some of that fortune wasn't planned. Most underhedged schemes now have the opportunity to increase their hedging at far more attractive levels than previously thought possible - despite the disastrous losses on (a selective sample of some of) their assets. Many have also benefitted from inflation hedge outcomes far superior to the increase in their inflation liabilities since Index Linked Gilts strategies will see returns greater than the capped growth of their future inflation driven pension expenditures.

I am rubbish at quotes on my little laptop!

It is ironical that despite the liquidity squeeze the leveraged bets on long gilts have paid off spectacularly for many funds.

I wonder how many are now looking to restructure their portfolios, for example by reducing level of LDI leverage or even moving into direct investments.

The thing many people don't understand about risk is that almost nothing is riskless. However, overall, investors tend to be rewarded in proportion to the risks they take, so long as their affairs are not exposed to termination events. Of course there are exceptions when things are very unbalanced.

For example, for many years pension schemes were ideally suited for taking equity risk to fund their ten year plus outflows and thereby earning the premium for stomaching the short term volatility which other investors couldn't tolerate. That allowed enhancements of benefits to levels well above their original promises.

I also suspect the consultants understanding of the risks of rising interest rates on LDI funds held by db schemes are much better for the recent troubles, and will be incorporated into consideration of investment strategies going into the next period of higher inflation/rates than over the last decade.

Chris

[Alaric]

A piece in the Mail

https://www.dailymail.co.uk/news/articl ... plode.html

I'm not sure it's completely reliable.

It's now much less common for schemes to hold equities, so the effect of changes to dividend taxation is no longer great.
Also it was never really an additional tax on pension funds, rather it removed a rebate that pension funds could claim. That arguably was being exploited, so that returns of capital were structured as dividends to get the rebate.

I think it's on the mark though to blame accounting rules. If there was a rather softer way of reporting pension deficits, maybe investment in LDIs and the current crisis avoiding. It occurs to be that when one Company takes over another Company and pays over the odds, that doesn't show up as an immediate loss, but is bundled into the nebulous concept of goodwill. So cancel a deficit by adding phantom assets, something like "expected value of equity risk premium pension funding" or "value of reversion to mean of fixed interest assets". That's assuming future outgo is valued at a risk free rate of return, rather than an expected rate of return based on the scheme's investment policy.

[XFool]

A piece in the Mail

https://www.dailymail.co.uk/news/articl ... plode.html

I'm not sure it's completely reliable.

Golly!

I think it's on the mark though to blame accounting rules.

Possibly so. Anyone know what the thinking was behind this at the time?

I confess to still being confused about all this - I just don't know anything like enough to understand the matter properly. Thoughts:

1. How do pension funds actually work?

By this I think I really mean how exactly did/does a closed pension fund run down?

2. LDI?

I thought this was originally sold to us, after the Dot Com crash, simply as pension funds buying Gilts in preference to "risky"(i.e. volatile) equities.
The bonds would "Meet pension fund liabilities as they became due", whatever that meant. How did this work exactly? How did it help other than in the case of a pension fund in run off? What was wrong with volatile (but dividend paying) equities for a pension fund operating for the long run and not yet closed and in run off?

I guess it makes sense in the long run, somewhat like how, in the past, personal pensions were converted into an annuity at retirement.
To do this themselves pension funds would need to do the same job as insurance companies/annuity providers do.

3. LDI+?

Sounds like the above simple 'solution' morphed over the years into something more complicated. Complicated by 'financial engineering' and financial institutions with products to sell?

[Alaric]

[
1. How do pension funds actually work?

By this I think I really mean how exactly did/does a closed pension fund run down?

One way of doing this is to purchase an annuity when members reach their retirement age. Paying out the cash Pension Commencement lump sum is easy enough, you just need the cash on hand or from a maturing bond. Buying an annuity is more complex because the fund doesn't know how much it will cost. The best it can attempt to do is to invest in assets similar to those an insurance company would use to back the annuity on the premise that the quoted price of annuities will move in a similar manner to those assets.

If a fund is in deficit, that means that eventually the assets will run out while there are still beneficiaries. Alternatively if a sponsor is making up the shortfalls you could look on it as the fund not being able to finance the retirement cash or the annuity purchase without getting an external contribution.


Instead of this, pension funds can keep the annuity liabilities on their books. This avoids any need to find immediate amounts of cash to finance annuity buyouts, but can run into similar problems of running out of money with longevity of pensioners thrown in as an additional risk.

Back in the days when funds were open to new accruals and new members, it was considerd quite safe to adopt a HYP like strategy. Invest in equities and rely on the cash flow from dividends and contributions to never have to sell assets or not retain the proceeds if the assets matured. That's provided you didn't have accounting rules which forced sponsoring employers to declare a loss and a deficit every time asset values fluctuated downwards.

Invest in low interest bonds and not have any new money from employers and employees and the balancing act between income and outgo becomes more critical.

[ChrisNix]

A piece in the Mail

https://www.dailymail.co.uk/news/articl ... plode.html

I'm not sure it's completely reliable.

Golly!

I think it's on the mark though to blame accounting rules.

Possibly so. Anyone know what the thinking was behind this at the time?

I confess to still being confused about all this - I just don't know anything like enough to understand the matter properly. Thoughts:

1. How do pension funds actually work?

By this I think I really mean how exactly did/does a closed pension fund run down?

2. LDI?

I thought this was originally sold to us, after the Dot Com crash, simply as pension funds buying Gilts in preference to "risky"(i.e. volatile) equities.
The bonds would "Meet pension fund liabilities as they became due", whatever that meant. How did this work exactly? How did it help other than in the case of a pension fund in run off? What was wrong with volatile (but dividend paying) equities for a pension fund operating for the long run and not yet closed and in run off?

I guess it makes sense in the long run, somewhat like how, in the past, personal pensions were converted into an annuity at retirement.
To do this themselves pension funds would need to do the same job as insurance companies/annuity providers do.

3. LDI+?

Sounds like the above simple 'solution' morphed over the years into something more complicated. Complicated by 'financial engineering' and financial institutions with products to sell?

Some balance is required here.

Leveraged LDIs could be seem as a leveraged bet on longish interest rates falling. With QE rampant, and base rates on the path to zero, it was a great asset bet!

And a form of offset to the increase in the value of gilts which would have to be held to cash flow match outflows, a figure which many mistakenly refer to as the value of the liabilities.

But with inflation breaking away in 2022 it really has been a lousy bet this year, so quite a lot of the good performance has been given back.

Meanwhile, the value of gilts which would have to be held to cash flow match outflows has fallen considerably.

Not all bad news, by any event.

But leveraged investments are plainly contrary to the spirit of pensions regulation, so one might expect to those regs to be extended to preclude investments in leveraged funds such as leveraged LDIs.

[XFool]

Leveraged LDIs could be seem as a leveraged bet on longish interest rates falling. With QE rampant, and base rates on the path to zero, it was a great asset bet!

And a form of offset to the increase in the value of gilts which would have to be held to cash flow match outflows, a figure which many mistakenly refer to as the value of the liabilities.

This is the bit I don't really understand. OK, in a falling interest environment the value of fixed coupon investments would rise, so they could be sold down gradually at higher prices than bought to supply ongoing cash. But in such an environment so would the value of equities, and they probably would have a higher and rising dividend yield as well. So why the problem with equities? Volatility? But then, in a rising interest rate environment, bonds would fall in value as well as equities. I really cannot see the great advantage of the original, simple(?) liability driven (matched) investing (unless the bonds were held to redemption). Perhaps the real advantage is to the sponsoring company's balance sheet liabilities, not the pension fund?