Investing for DB pension schemes

[Alaric]

Having Googled 'funding on a buy out basis' it is no different from what I had understood so I am none the wiser and my views have not changed.

I think the Legal & General model is that they take on mortality and investment risks for a price. That price is likely to depend on Gilt yields. I suspect they take advanatage of their size and profit from illiquidity and risk premiums by actually investing in fixed interest assets that are less secure and less liquid than Gilts. They would have the cushion of the shareholder funds to fall back on.

Being an Insurance Company, their solvency tests would be more stringent than a penion fund. It's likely then that they are expected to consider scenarios where interest rates change in either direction. It's known they were writers of LDIs through their LGIM subsidiary. As to whether they used it for portfolio managenent, that may have to await their next set of accounts or detail scrutiny of previous ones.

When a pension fund quotes "funding on a buy out" basis, it's probably trying to guess what LGEN and others in that market would ask for.

[scotview]

I've seen a couple of items on Bloomberg and Sky this morning saying that the BoE are going to extend their bond buying program beyond mid October.

There must still be some concern.

[Dod101]

Having Googled 'funding on a buy out basis' it is no different from what I had understood so I am none the wiser and my views have not changed.

I think the Legal & General model is that they take on mortality and investment risks for a price. That price is likely to depend on Gilt yields. I suspect they take advanatage of their size and profit from illiquidity and risk premiums by actually investing in fixed interest assets that are less secure and less liquid than Gilts. They would have the cushion of the shareholder funds to fall back on.

Being an Insurance Company, their solvency tests would be more stringent than a penion fund. It's likely then that they are expected to consider scenarios where interest rates change in either direction. It's known they were writers of LDIs through their LGIM subsidiary. As to whether they used it for portfolio managenent, that may have to await their next set of accounts or detail scrutiny of previous ones.

When a pension fund quotes "funding on a buy out" basis, it's probably trying to guess what LGEN and others in that market would ask for.

Thanks. Yes, thanks. These views/opinions are very much what I feel about the situation as well. All of this illustrates of course how little most of us really understand about this.

Dod

[ChrisNix]

But to stick to the underlying point, even if there was/were a middle man/men involved, do you deny that a substantial amount ended up funding hedgies (and analagous structures) playing the carry trade?

Yes

Interesting given the banks are substantial lenders to LDI funds.

[dealtn]

But to stick to the underlying point, even if there was/were a middle man/men involved, do you deny that a substantial amount ended up funding hedgies (and analagous structures) playing the carry trade?

Yes

Interesting given the banks are substantial lenders to LDI funds.

What's that got to do with hedge funds, even if true?

[micrographia]

Quite right to challenge that comment but I thought public sector schemes were pretty well all unfunded, and they are just paying benefits 'out of the till'

Local government is funded and so were nationalised industry ones. Most of those were privatised with the sponsoring employers, but perhaps not the miners' scheme.

From the horse's mouth
https://commonslibrary.parliament.uk/re ... /cbp-8478/

The six largest public service pension schemes in the UK – the schemes for the Armed Forces, the Civil Service, NHS, Teachers, Police and Firefighters (which operate on a pay-as-you-go basis) and the Local Government Pension Scheme (which is funded) are statutory defined benefit (DB) pension schemes (i.e. they provide pension benefits based on salary and length of service).

Another big one that is funded is the one for university staff. https://www.uss.co.uk/
https://www.uss.co.uk/how-we-invest/how ... e-invested

But note that the USS is a private rather than public sector scheme

https://www.uss.co.uk/about-us/who-we-are


We're Universities Superannuation Scheme

Established in 1974, we're the largest private pension scheme in the country, and the principle pension scheme for universities and Higher Education institutions in the UK

Off-topic, but it's also not what it once was. It used to be a straightforward final salary DB scheme with options to buy extra years and contribute to a separate money purchase AVC scheme with the Pru. The Final Salary DB scheme closed to new members in 2011 and new contributions in 2016. It was replaced with a career revalued benefits DB scheme with a salary threshold and no way to make additional contributions - once you earn more than the threshold any contributions go into a DC pot instead, as do benefits transferred in from another scheme or any AVCs. The Prudential MPAVC scheme ran alongside the new AVC arrangements for a while, but that has also been closed to new contributions for a few years now. So if you joined prior to 2011 you will have a final salary DB component, a career revalued benefits DB component and possibly a DC component that may be composed of 2 pots, one with USS and one with the Pru. All with different rules and benefits. If you joined in the last 5 years you have a watered down DB/pretty standard DC hybrid scheme, but you're meant to be grateful there is any DB component left at all. As for how well funded it is - well, thats a story in and of itself. The last USS valuation is the direct cause of much of the current unrest in the higher education sector.

I'd imagine plenty of long-standing corporate schemes are similarly complex. Is it any wonder there is so much confusion about pensions?

Regards, EEM

[micrographia]

Back on topic, this explanation in laymans terms was given by the Beeb in response to todays shenanigans;

"What does the government's cost of borrowing have to do with pension funds? The government raises money for its spending by selling bonds (also known in the UK as gilts) to investors. These are basically a type of IOU, with the government promising to pay the money back, plus interest, within a given time frame – say over 10 years. Pension funds invest billions of pounds of your money in government bonds. Following Chancellor Kwasi Kwarteng's mini-budget, investors wanted a much higher return for investing in bonds. In order to protect themselves against sharp rises in government borrowing costs, pension funds themselves invest in products which act as a kind of insurance. Because of the sharp rise in the cost of borrowing following the mini-budget, the people who provide this insurance wanted a payment from the pension funds. This forced pension funds to sell bonds to satisfy these requests. As they sold bonds, the cost of government borrowing continued to rise - which led to more bond sales, creating a kind of "doom spiral". At this point, the Bank of England stepped in to buy up bonds and bring the cost of borrowing down. That succeeded but only for a time... Hence this morning's fresh intervention from the Bank."

Regards, EEM.

[Alaric]

In order to protect themselves against sharp rises in government borrowing costs, pension funds themselves invest in products which act as a kind of insurance. Because of the sharp rise in the cost of borrowing following the mini-budget, the people who provide this insurance wanted a payment from the pension funds.

Pension funds should have no particular need to protect themselves from a rise in government borrowing costs as they are the lenders to governments and would get a higher return on future investment if government borrowing costs increased. Their bigger perceived problem which LDIs were meant to solve was that when government borrowing costs fell, the value placed in the pension liabilities stretching into the future would increase. So would the value of their holdings of government securities, but not by as much as the increase in pension liability. That's particularly so if they were under funded. The accounting rules are such that this phantom loss would show up in the sponsor's accounts.

What seemed to happen was that when interest rates increased, the cost of insuring against their fall increased as well, requiring additional funds to have to be provided as margin. What newspaper reports seem not to make clear is that it was the LDI fund providers who would go under, not the pension funds themselves as they take the sponsoring organisation with them if they run out of assets.

[ChrisNix]

In order to protect themselves against sharp rises in government borrowing costs, pension funds themselves invest in products which act as a kind of insurance. Because of the sharp rise in the cost of borrowing following the mini-budget, the people who provide this insurance wanted a payment from the pension funds.

Pension funds should have no particular need to protect themselves from a rise in government borrowing costs as they are the lenders to governments and would get a higher return on future investment if government borrowing costs increased. Their bigger perceived problem which LDIs were meant to solve was that when government borrowing costs fell, the value placed in the pension liabilities stretching into the future would increase. So would the value of their holdings of government securities, but not by as much as the increase in pension liability. That's particularly so if they were under funded. The accounting rules are such that this phantom loss would show up in the sponsor's accounts.

What seemed to happen was that when interest rates increased, the cost of insuring against their fall increased as well, requiring additional funds to have to be provided as margin. What newspaper reports seem not to make clear is that it was the LDI fund providers who would go under, not the pension funds themselves as they take the sponsoring organisation with them if they run out of assets.

I'm not familiar with the plumbing , but my understanding is that when rates fell the LDI's leveraged gilts positions became more valuable and they could send margin/excess collateral TO the pension schemes. So they'd had a good run for many years.

But no one had looked properly at the risk reward ratio, for example chances of rates going lower versus higher, and the LDI exposure was maintained.

When the inevitable rate increases came, the LDI's leveraged gilt holdings fell in value, and the lenders/counterparties to the LDIs wanted more margin. Hence urgent calls to pension schemes to send cash/collateral FAST!

E. & O.E.

Chris

[micrographia]

The only firm ground that I can find to stand on while trying to understand this whole affair is that at some point some DB pension funds had an urgent need to raise cash, tried to do do by selling gilts and, in the case of long-dated gilts at least, were unable to find a buyer. Hence the BoE stepping in to "restore an orderly market" as they say. As noted above in this thread, it was (is?) a liquidity crisis.

Still not sure why they needed the cash, still not sure what the consequences of those funds going belly up would be, still not sure which funds are involved. Happy to learn LGEN aren't directly on the hook.

EEM

[Dod101]

The only firm ground that I can find to stand on while trying to understand this whole affair is that at some point some DB pension funds had an urgent need to raise cash, tried to do do by selling gilts and, in the case of long-dated gilts at least, were unable to find a buyer. Hence the BoE stepping in to "restore an orderly market" as they say. As noted above in this thread, it was (is?) a liquidity crisis.

Still not sure why they needed the cash, still not sure what the consequences of those funds going belly up would be, still not sure which funds are involved. Happy to learn LGEN aren't directly on the hook.

EEM

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

[XFool]

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.

And yet... many available reports on the Internet from financially qualified entities describing how most DB pension funds are now highly funded. Even funded to the level needed for a buy out!

[Alaric]

[
And yet... many available reports on the Internet from financially qualified entities describing how most DB pension funds are now highly funded. Even funded to the level needed for a buy out!

One other take on this is that even if they were fully funded, they had the potential problem that the mean term of the liabilities exceeded the mean term of the assets. That's particularly the case if they had a lot of liability for people yet to reach retirement age. As a consequence if interest rates reduced, the market value of their fixed interest assets would increase, but the value placed on the liabilities would increase even more. This creates a loss to be disclosed in the sponsoring body's accounts. LDIs may have been marketed to plug that gap.

I doubt that's the whole story as leverage fits in somewhere.

There's nothing recent at the Institute of Actuaries site, but this is a paper from 2018.
https://www.actuaries.org.uk/system/fil ... _final.pdf

No mention that I could see of the margin call risk.

[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

Dod,

I was told about significant margin calls at beginning of September.

That makes sense because rates have been rising for months.

I think the crtical thing which happened at the end of Septmeber was that the quantum of margin calls escalated hugely almost overnight.

Hence a liquity squeeze on the underlying LDI funds (and any other undhedged funds which were leveraged long gilt players.

Chris

[dealtn]

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.

[Alaric]

It appears the Bank of England have given pension and LDI funds until Friday to sort themselves out by announcing it will discontinue its Gilt market support.

What sort of losses will pension funds incur by unwinding their positions and reverting to vanilla funding?

https://www.reuters.com/world/uk/bank-e ... 022-10-11/
https://www.theguardian.com/money/2022/ ... nsion-safe

[ChrisNix]

It appears the Bank of England have given pension and LDI funds until Friday to sort themselves out by announcing it will discontinue its Gilt market support.

What sort of losses will pension funds incur by unwinding their positions and reverting to vanilla funding?

https://www.reuters.com/world/uk/bank-e ... 022-10-11/
https://www.theguardian.com/money/2022/ ... nsion-safe

I'd assume that whatever the market value is of the LDI exposure there is a process for putting in place its realisation. But beyond any margin held, the main impact of withdrawal may be to remove further exposure to rising gilt yields.

Bearing in mind real yields were 1 1/2 % higher pre LDI there is plenty of scope for further yield rises. If that were to occur the schemes would be better funded than if they'd retained their nominal LDI exposure.

The secondary question is the trustees' attitude to no longer having a bet against interest rates falling. If that is considered too much of a 'risk' they may decide to reduce 'risk' assets held, i.e. equities and property.

Large number of permutations dependent on subjective value judgements, so no objective generalisations about 'funding levels'.

[Nimrod103]

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?

[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.

[Nimrod103]

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.

I still may have got this wrong, but AIUI the faster pension funds liquidate assets to meet these commitments, the more money they lose. And if they do this, it will have a major deleterious effect on the wealth of pension funds and hence on the City, which the BoE is there to protect. I presume the BoE pension fund is not impacted.