Swapping a risk for a crisis
Once again the financial markets need protecting from their own genius
Last week, the Bank of England stepped in with rescue measures to prevent a crisis in UK pension funds. For most people who expect to depend on a pension fund for their financial well-being – either now or in the future – news of the crisis came at the same time as news of the rescue, so we were reassured even before we knew that we needed to panic.
But the rescue arrangements end on 14 October. Pension fund managers, and those who oversee them, have just 10 days to get things sorted if the problem isn’t to start up again.
Since the turn of the century, when stock markets took a bit of a tumble, a significant proportion of UK pension funds have not had sufficient assets to pay off all the pensions that scheme members have earned. But most of those pension payments are way off into the future so, typically, we don’t describe pension funds as “insolvent”; we use the less frightening term “in deficit”. There was – and still is – a fair bit of time for employers to build up the assets to a sufficient level. There is a regulator to ensure that employers do just that and a statutory protection fund that acts as a fallback for those cases where the employer itself goes bust before the deficit has been fully plugged.
So how could there have been an urgent crisis last week with pension funds unable to meet their immediate payments? The answer lies in the rather strange investment strategy that pension funds have pursued in the name of “de-risking” – an Orwellian turn of phrase if ever there was one in which a de-risking strategy replaces a perceived long-term risk with a short-term crisis.
The idea at the heart of the approach was a pretty simple one. After an earlier bout of turbulence in the stock markets which had left pension fund finances looking distinctly shaky, some investment managers came up with the idea that funds should stop investing in volatile company shares and instead invest in much safer, more predictable securities. Pension schemes would (as they always had done) ask their actuaries to estimate the future outflow of pension payments way into the future and ask their investment managers to buy assets (generally known as “fixed interest investments”) which would be expected to produce income streams that matched, as closely as possible, those future pension payments. By this means, the stock market risk had been removed: hence the term “de-risking”.
But the sheer conservatism of the investment strategy meant that returns were – and would remain – much lower than could be obtained from the faster-growing assets held previously. The result of these weaker investment returns was that schemes needed to buy more investments. (Imagine that you are living off a fund of £500,000 that pays 10% pa in interest. If you switch into a fund that pays only 5% pa, your income will halve unless you can double the size of the fund to £1m.)
Despite the weaker returns, some pension funds that didn’t have sufficient assets to pay for the future pension obligations – but by no means all of them – chose to switch into more stable, investments. Employers were persuaded to meet the extra cost in exchange for the reassurance that, once the deficit had gone, it should be gone forever.
Well, that was the original idea. But, somewhere along the line, this simple matching approach morphed into something called Liability Driven Investing (“LDI”). Schemes using LDI abandoned the simple approach of buying assets and using the income from those assets, along with future sales, to pay pensions. Instead, they entered into investment contracts which meant that they became contractually committed to making and receiving payments from other investors. In the language of the investment industry, these pension funds entered into contracts known as swaps, derivatives, repos and others.
These complex contracts were designed to re-create the effect of the matching approach (the aforementioned de-risking) but using only a small proportion of the fund’s assets. The majority of the pension fund’s assets could then be invested in the traditional faster-growing assets. Payments to and from other investors under these swaps and derivatives etc depended on the state of the market. If all went well, the payments and this more complex form of de-risking would turn out fine.
But the whole point of de-risking is to defuse situations where all is not going well. And, last week, things did not go well at all. The sudden changes in interest rates following the Government’s fiscal event (aka the Kami-Kwasi budget) resulted in pension schemes being called upon to make substantial immediate payments without having sufficient cash flow available to do so. The Bank of England responded with an announcement that it was setting aside £65bn to prop up the market for 2½ weeks.
The Financial Times reported on Friday that urgent meetings were being scheduled to plan for what happens after that. At the moment, we don’t know. Some industry experts report that the Pensions Regulator had “zealously promoted” the use of these LDI strategies. If it’s true, I think the Bank needs to ask the regulator to stop.
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Simon, perceptive as ever. As this story has unfolded I have reached the following conclusions:
1. There's always cause for concern when you see everyone doing the same thing. It rarely ends well. It's a consequence of herding among advisers, a regulatory regime that discourages independent thought and buyers who do not ask basic "what if" questions about things they don't understand.
2. As you point out, things go wrong when people stop thinking about pension balance sheets as two sets of long term cash flows and become obsessed by mark to market values.
3. I suspect there's also a problem, which is not peculiar to pensions, when people become seduced by ratios and differences and forget what's driving the underlying "big" numbers. It's why people lose sight of the power of leverage.
Excellent piece Simon.