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BT Group Fourth Quarter Results

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Gengulphus
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Re: BT Group Fourth Quarter Results

#138284

Postby Gengulphus » May 11th, 2018, 11:35 am

Arborbridge wrote:
TUK020 wrote:I fear that I do not understand the chain of reasoning.
A rise in interest rates will increase the rate of return on a long term gilt.
For a gilt already owned, it does not do this by increasing the interest payment. It does it by reducing the price of the gilt.
How does this reduce the deficit?

I can see a long term effect when the bond matures, the money can be recycled into a new bond at a higher interest rate. But I fail to see how increasing interest rates magically cuts the pension deficit.

What am I missing?

As Dod says, it is nothing to do with the price of the bonds being discussed here, but the liability as determined by teh actuaries to the BT pension fund - and that liability in turn is heavily dependent on the gilt rate. Mixing the fact that BT are issuing a bond with the gilt rate in the same disussion led to the misunderstanding.

I think TUK020's problem may well be to do with understanding why the liability as determined by the actuaries is heavily dependent on the gilt rate. So perhaps an explanation is in order...

Suppose I had to pay you say £10k per year for say the next 20 years. To make the obligation concrete and the formulae as simple as possible, I'll assume that I have to pay the entire £10k for each year at the start of the year. Assuming I can find investments with a completely safe rate of return of R% per year, how much capital would I have to have in those investments to be able to meet my obligation?

Well, the first year's payment is due immediately, so I have to have £10k available to meet it. And the second year's payment is due in one year's time, so to meet it, I have to have the sum that will grow to £10k after being invested for one year at a return rate of R%. That multiplies the sum by (1+R/100), so I have to have £10k / (1+R/100) available now to be able to make that payment after investing it for a year. And the third year's payment is due in two years' time, so I similarly need to have £10k / (1+R/100)^2 available now to be able to make that payment after investing it for a couple of years. And so on, right up to the 20th year's payment, which requires £10k / (1+R/100)^19 available now. And so to meet my obligation to make all 20 years' payments, I need to have the sum of all those amounts available now, i.e.

£10k + £10k/(1+R/100) + £10k/(1+R/100)^2 + ... + £10k/(1+R/100)^18 + £10k/(1+R/100)^19

That formula is a bit cumbersome, but I can simplify it if I set r = 1/(1+R/100) - it becomes:

£10k + £10k * r + £10k * r^2 + ... + £10k * r^18 + £10k * r^19

Or:

£10k * (1 + r + r^2 + ... + r^18 + r^19)

There's a further simplification available. If r=1, then that's just £10k * (1+1+1+...+1), with 20 1's in the second part), so £10k*20 = £200k. Otherwise, we'll leave the sum (1 + r + r^2 + ... + r^18 + r^19) unchanged if we multiply it by 1-r and then divide it by 1-r (this doesn't work if r=1 because the multiplication produces 0, and then the division produces the indeterminate 0/0). But the multiplication produces:

(1-r) * (1 + r + r^2 + ... + r^23 + r^24) = (1-r) + (r-r^2) + (r^2-r^3) + ... + (r^18-r^19) + (r^19-r^20)

= 1 - r + r - r^2 + r^2 - r^3 + ... + r^18 - r^19 + r^19 - r^20

= 1 - r^20,

since the - r and + r cancel each other out, as do the - r^2 and + r^2, and so on up to the - r^19 and + r^19. So the division then produces (1-r^20)/(1-r), and so the capital I need to meet my obligation to make all 20 years' payments is £200k if r=1 and otherwise £10k * (1-r^20)/(1-r).

Now add one small-but-significant complication: rather than the payment obligation starting immediately, suppose it starts in N years' time (and then continues for 20 years after that). In that case, the capital I require reduces, because I get N years of growth at R% to build it up to the amount determined by the formulae in the last paragraph. That growth multiplies the capital by (1+R/100)^N, so the capital required at the start is divided by that, or equivalently multiplied by r^N. So the capital required is £200k if r=1 and otherwise £10k * r^N * (1-r^20)/(1-r)

Now look at how this changes as R and N change - for each value of R, the safe rate of return, we need to calculate r = 1/(1+R/100) and then calculate the required capital. Doing that for a selection of values for R and N:


The point of all this is that this is roughly the situation a pension fund faces about the capital they require with respect to someone who is entitled to a £10k flat pension from the age of 65 if they are currently aged 65, 50, 35 or 20 for the last four columns respectively, assuming they live to age 85, and that it is very sensitive to changes in the safe rate of return, especially for the younger future pensioners - e.g. the last column shows that a 0.5 percentage point decrease in the safe rate of return can add about 30% to the amount of capital required now for safe funding of the 20-year-old's future pension.

Of course, the pension fund isn't guaranteed that its pensioners and future pensioners will live to exactly age 85, but as long as it has a large number of them, they should average out at around that. And there are all sorts of other complications - increasing lifespans, indexation of pensions, possible future changes to safe rates of return and to pension regulations, the fact that younger future pensioners have probably built up a smaller pension entitlement so far, etc, etc, etc. So the real actuarial calculations are nothing like as simple as those above, and an actuary's job is hugely more difficult and complex than is describable in a post! But the above captures the gist of the problem: small changes in investment rates of return can make big differences to the capital required now to safely cover future pension liabilities, and the further they are in the future, the bigger this effect - e.g. a 0.5 percentage point decrease in investment returns only makes about a 5% difference to the capital required now to cover the future payments to a 65-year-old, compared with the ~30% difference for the 20-year-old. (As an aside, the same effect actually applies to all future liabilities, not just pension liabilities - it's just that pension liabilities are likely to be in the especially distant future and so are particularly affected by it.)

TUK020's point about such effects also affecting asset values is entirely valid, with the equivalent "the further into the future, the bigger" effect being that they apply especially to indefinite-duration or long-duration investments such as shares and long-dated gilts. But if for instance a company has a £10b pension deficit due to its pension scheme having £40b of assets and requiring £50b of assets to safely cover its future pension liabilities, and a 0.5 percentage point drop in the safe rate of return causes both the assets and the asset requirements to increase by 20% (as a very rough round-figure guess as to the average effect across the ages of the future pensioners), then those two figures change to £48b and £60b respectively - and the deficit grows to £12b.

The other big issue in this area is just what the "safe" long-term investment rate of return is. Long-dated gilts are generally reckoned to be the safest form of long-term investments (*) and so the rate of return on long-dated gilts gives a reasonable basis for determining it, which is the basic explanation for the connection between pension deficits and interest rates via long-term gilt rates. In practice, higher rates of return are achievable very safely, and I would certainly expect any well-run pension scheme to do so to at least some extent. As even a small increase in the safe future rate of return assumed by the pension deficit calculation will lead to a big reduction in the capital required, it will produce a big reduction in the pension deficit (note that the value of the pension scheme's assets is not affected by that assumption - it will be affected by the market's assumption about the safe rate of future investment returns, but not by the rate assumed in the pension deficit calculation). So companies have a strong incentive to assume as high a safe rate of investment returns in the pension deficit calculation as they can to keep the calculated pension deficits low - and correspondingly, governments / regulators have a strong incentive to keep the assumed rate of investment returns down to a figure that really is as safe as reasonably possible. The conflict between those incentives leads to rules about how a pension deficit should be calculated that specify some sort of compromise between the two. The safe rate of return that produces to be assumed by pension deficit calculations may not be the same as what is actually reasonably safely achievable - and as the above illustrates, even small differences can produce quite major differences in the calculated pension deficit.

The net result is that pension deficits for defined-benefit pension schemes are the difference between two very large numbers - the actual value of the scheme's assets, and a calculated estimate of what value of assets is required now to meet very long-term liabilities. And the second figure (but not the first) is very sensitive to small changes to the safe investment rate it assumes. That combination of being the difference between two very large figures and one of them being an actual current figure and the other very much an estimate based on long-term interest rates makes them highly volatile.

To make "very long-term" concrete, for an open scheme one might think of the liabilities becoming due an average of ~30 years in the future (assuming it has assets for employees averaging about halfway through an ~40-year working life, and pension payments will need to be paid out of it for pensioners averaging about halfway through an ~20-year retirement). Such long-term forecasts really are very difficult indeed, so I'm not saying that the estimates are being made incompetently, excessively roughly, or anything like that - just that high volatility of the calculated pension deficits (and especially their sensitivity to interest rates) is an inherent aspect of the way they're calculated. (So why not use a better method of calculating them, one might ask... To which the answer is basically that no-one has found one that is better, when judged by the standards of all those involved - employees, companies, regulators and governments - weighted by their influence on the standards.)

For a scheme that has been closed to future accruals (so not just no new members, but also no additions to existing entitlements of existing members), each year that passes makes it that much less long-term and so more accurately forecastable. So the problem can be expected to wind down following the BT pension scheme's closure to future accruals. But only very slowly, and so the small amount of winding-down per year can be expected to be swamped by interest-rate effects for many years to come.

(*) Which doesn't mean absolutely 100% safe - governments can in principle find themselves forced to default - but just that there's nothing safer (and if a situation develops in which the government is forced to default, it's probably one in which all investment bets are off anyway).

Gengulphus

tjh290633
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Re: BT Group Fourth Quarter Results

#138290

Postby tjh290633 » May 11th, 2018, 12:00 pm

Another point to make is that pension funds do not invest in the safest possible things. Property is a favourite medium, and that can be high street shopping premises, warehousing, farmland, you name it. The property will generate income at a better rate, should accumulate in value, and the income can provide the cash for pensions in payment.

The actuarial valuation is about the most pessimistic view possible, because it assumes that for every existing future liability you buy securities with a redemption value on that future date which matches the liability on that date.

TJH

Gengulphus
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Re: BT Group Fourth Quarter Results

#138294

Postby Gengulphus » May 11th, 2018, 12:16 pm

tjh290633 wrote:Another point to make is that pension funds do not invest in the safest possible things. Property is a favourite medium, and that can be high street shopping premises, warehousing, farmland, you name it. The property will generate income at a better rate, should accumulate in value, and the income can provide the cash for pensions in payment.

The actuarial valuation is about the most pessimistic view possible, because it assumes that for every existing future liability you buy securities with a redemption value on that future date which matches the liability on that date.

Agreed - basically, that's the sort of thing I was getting at when I said "The safe rate of return that produces to be assumed by pension deficit calculations may not be the same as what is actually reasonably safely achievable", but yes, that was a bit abstract... An actual example helps make things more concrete, and property is an excellent example!

Gengulphus

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Re: BT Group Fourth Quarter Results

#138341

Postby Walrus » May 11th, 2018, 2:05 pm

Moderator Message:
text deleted. Off topic. Please keep posts relevant to the ops post. Thanks in advance. Raptor.

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Re: BT Group Fourth Quarter Results

#138345

Postby Dod101 » May 11th, 2018, 2:15 pm

I have finally discovered the part of my post 138277 of this morning which was removed. I have no history of being insulting, abusive or irrelevant in my posts either under Dod101 or Dod1010 since TMF closed, and until the last day or two (Raptor also removed something of mine; I know not what) have hardly ever had a post removed or amended for any reason. I opened my post by saying 'Now we are getting whistlers in the dark'. That was merely an opinion on my part and it is still my opinion that those buying into BT at this time are being very brave and to some extent are whistling in the dark.

However to anyone who was offended by the remark you have my apologies. I had no intention of being insulting or offending anyone.

Dod

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Post left but no further posts on subject will be allowed and will be removed, with no pm to poster. Raptor

TUK020
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Re: BT Group Fourth Quarter Results

#138355

Postby TUK020 » May 11th, 2018, 2:39 pm

Gengulplus,
Thank you for the effort that has gone into answering my question, and bravo for the clarity that you achieved.
I now feel a little guilty about asking a follow up question in case it becomes as complicated......

How does the rate of inflation affect all of this?

tuk20

Gengulphus
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Re: BT Group Fourth Quarter Results

#138372

Postby Gengulphus » May 11th, 2018, 3:36 pm

TUK020 wrote:How does the rate of inflation affect all of this?

The most obvious way is that if the payouts by the pension are inflation-linked, that has to be taken into account when the pension scheme is working out how much capital is needed to safely fund them. There are other ways as well, often less direct - e.g. the rate of inflation will affect government policy on interest rates, which will affect interest rates and thus the calculation of the pension deficit as I previously described...

Basically, this was covered briefly in my previous post when I wrote "And there are all sorts of other complications - increasing lifespans, indexation of pensions, possible future changes to safe rates of return and to pension regulations, the fact that younger future pensioners have probably built up a smaller pension entitlement so far, etc, etc, etc. So the real actuarial calculations are nothing like as simple as those above, and an actuary's job is hugely more difficult and complex than is describable in a post!". And as for a more detailed description of them, while I think I have a decent broad-brush understanding of what goes on in pension deficit calculations and other financial pension issues, I'm afraid I don't have a really detailed understanding, so I cannot really go into much more detail than that!

Gengulphus

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Re: BT Group Fourth Quarter Results

#138435

Postby bluedonkey » May 11th, 2018, 8:22 pm

onslow wrote:With a PE ratio of just over 8(!) and dividend yield of 7%(!!) this is a buy. This is not a company with a limited lifespan, it has real infrastructure, multi year/decade contracts and is making money. At these levels you are being well compensated for any residual risk.

I'm buying.

Crikey, yield of 7% and P/E of 8. In the absence of any prospect of a dividend cut, it does seem like an obvious HYP candidate. SI chaps.

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Re: BT Group Fourth Quarter Results

#138444

Postby paulnumbers » May 11th, 2018, 9:41 pm

Comments from embittered ex-employees can be taken with a pinch of snuff, as can complaints from those who use alternative providers and don't like the service they get from Openreach. Hard lines.


I was actually treated very well and it was a very enjoyable job for me, a little too much at times. But I generally agree, you should probably take it with a pinch of salt, the view of BT I had was simply too small to draw a meaningful conclusion I think, but everything I did see was how to cut corners in every possible way for a quick buck. I was only a lowly employee.

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Re: BT Group Fourth Quarter Results

#138478

Postby Hypster » May 12th, 2018, 8:12 am

idpickering wrote:
Hypster wrote:
Hi Ian, BT already represents 6% of my HYP so is excluded from top-ups for a while. However, if it were eligible for top-ups I would do so.


I do get where you're coming from Hypster. I like a bargain too. Are they one of your largest holdings then? If so, of how many different holdings? As I mentioned, they (BT.A) are only 3% of my HYP so I've got room for a top up if I want.


My HYP has 18 holdings, the median weighting is 5.7%

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Re: BT Group Fourth Quarter Results

#138482

Postby Raptor » May 12th, 2018, 8:19 am

Moderator Message:
Please keep posts on topic. Any that are not relevant to OPs original post, maybe edited, deleted or moved, without PM. Thanks for your help and understanding. Raptor

tieresias
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Re: BT Group Fourth Quarter Results

#138679

Postby tieresias » May 12th, 2018, 11:08 pm

As a customer, shareholder, ex-employee and deferred pensioner of BT, and having also worked for OfCom and suppliers to BT, I think they are doing a very good job of balancing stakeholders' interests.


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