The Bank of England has this morning announced a new £10 billion per day facility that will be available indefinitely to ensure that pension funds remain solvent.
I just posted this on Twitter in response:
I have long argued that pensions need reform. It's always been my belief that private pension management was for the benefit of the City, not pensioners, and that reforms under Thatcher were always intended to fleece ordinary people by sending wealth upwards through financial institutions at long-term cost to pension returns.
I feel vindicated. If they had invested as I suggested almost twenty years ago this would not have happened and we would now have a Green New Deal.
Hasn't the time come to end the belief that speculation in financial markets is the basis for providing for old age? As I argued in 2010:
[There is a] fundamental pension contract that should exist within any society. This is that one generation, the older one, will through its own efforts create capital assets and infrastructure in both the state and private sectors which the following younger generation can use in the course of their work. In exchange for their subsequent use of these assets for their own benefit that succeeding younger generation will, in effect, meet the income needs of the older generation when they are in retirement. Unless this fundamental compact that underpins all pensions is honoured any pension system will fail.
As I also argued then:
This compact is ignored in the existing pension system that does not even recognise that it exists. Our state subsidised saving for pensions makes no link between that activity and the necessary investment in new capital goods, infrastructure, job creation and skills that we need as a country. As a result state subsidy is being given with no return to the state appearing to arise as a consequence, precisely because this is a subsidy for saving which does not generate any new wealth. This is the fundamental economic problem and malaise in our current pension arrangement.
I did a video on this here:
Might we move on, please, for all our sakes?
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YOU feel vindicated!
Join the club!
You were the first though in my more limited experience to marry pensions to green investment.
But let’s see this for what it is: the failure of market provision. The model does not work. That message needs to be rammed home to politicians incessantly after this.
In other words, the State has had to pay out anyway. So why did it embark on this escapade in the first place?
Useless, pathetic, biased policy making if there ever was any.
My view is that the markets should be made to compensate the Government.
In 1978 the Labour government introduced a state SERPS pensions scheme. Over the next twenty years various UK neo-liberal governments did everything they could to undermine it and replace it with private pensions until they finally got rid of it.
Does this mean that it was a good scheme or was it as they claimed unfair to lower earners?
Overall it was a very good scheme that was deliberately undermined
Similar techniques being used on the NHS then.
The loss of independent, mutual pension funds was disastrous. Another post-Thatcher neoliberal bungle with dreadful consequences. There is a Sky commentary on the BofE moves today that is at best muddled; but at least near the end the article focuses on these stern comments by Lord Wolfson, “the chief executive of Next and one of the most influential figures in British business, [who] said last week that he had written to the Bank in 2017, when Mark Carney was governor, outlining his concerns about LDI strategies. He said the strategy – buying gilts and then using them as collateral to obtain further exposure to the gilt market – ‘always looked like a time bomb waiting to go off.
…. …. The Commons Treasury Select Committee is now looking into the issue and is set to question the Pensions Regulator. The Financial Conduct Authority and the Bank are also likely to be asked what they knew.”
We need look no further than to challenge the Government, Parlaiment, the Central Bank, the Pension Regulator and the Pension Funds; to explain how Britain has ended by driving the Pension sector into the position that it is in, and was ever alllowed to be in, the LDI leverage/dreivatives market. This is appalling.
The best in-built protection against this kind of reckless risk-taking with pensions, it seems to me to be obvious: it is structural mutuality.
Absolutely and I think Professor Paul Spicker agrees that it is the benefits of the mutuality argument that gets drowned out under the profit driven spectre of ‘choice’.
It sounds as if the pension funds have been given a license to misbehave. They can gamble all they want and if they win they get to keep the proceeds and if they lose the BofE will prop them up. We’re seeing the concept of “too big to fail” spreading from banks through energy to pension funds. Here then are Aristotle’s predicted post-democratic oligarchs, presenting in corporate form as even he never envisaged society would be stupid enough to grant person status to corporations. Which sector will be next, and how does this end other than badly?
What exactly is the issue with pension funds?
I’ll have a go, and perhaps someone else can explain where I go wrong.
As I understand it, the problem is with defined benefit (DB) funds – the ones that pay pensions based on final salaries – not with defined contribution (DC) pensions – the ones where what you get out depends on what you put in (and how the investments perform: of course, if the fund performs badly, you might get out less than you put in, but it is what it is). And as far as I am aware, there is no issue with the solvency of annuity providers.
DB pension funds hold lots of gilts, because gilts provide the stable long-term income these pension funds need to pay pensions to their pensioners.
The issue is that gilt yields have risen markedly in the last few weeks. As most gilts are issued at fixed rates, rising gilt yields means the capital value of the gilt decreases. A 1% gilt looks more unattractive when the market rate rises from 3% to 4%.
That should not be an issue if the pension funds just held the gilts for the income they provide, and paid out the income to pensioners.
The problem is that DB pension fund trustees have been encouraged to employ “liability-driven investing strategies” (LDI) in recent years. Rather than simply managing their assets to produce a low-risk return, and seeking additional funding to cover gaps between the actuarial valuation of assets and liabilities, the pension funds have been trying to actively manage their liabilities using derivatives intended to hedge against inflation and interest rates and the like.
Derivatives come with downside risk, and the chance that a counterparty might demand sufficient collateral to meet any contractual obligations. It is the margin calls made by the derivative counterparties – the demand for additional collateral, as the gilts have lost value – that has caused the problem. The pension funds are in trouble because their gilts have fallen in value. Gilts are still their main investment, and they are being required to sell gilts at these low prices to get the cash to meet the margin call.
And that might leave them with insufficient assets to pay the pensions, which would make them insolvent. (Presumably this is balance sheet insolvency – more liabilities than assets, with no way to bridge the gap – rather than cashflow insolvency due to an inability to make pensions payments as they fall due?)
I might have expected the pension trustees to ask the sponsoring employer for more money, or ask for help from the Pension Protection Fund. But if the whole sector goes bust at the same time, that might not work.
How did we get here? Pension trustees sucked into the world of casino investment banking, thinking that a world of low inflation and low interest rates might last forever?
You summarise it very well as far as I can see
Imagine a pension scheme has one member who is contracted to receive a single one off payment of £1 in 30 years time.
The risk free solution is to buy today a zero coupon gilt that matures in 30 years time – whatever happens, you will be able to deliver £1 to your pensioner as required. You are asset/liability matched; if rates rise the price of your gilt will fall but you don’t care because it will always deliver what you need (£1 in 30 years).
Now, imagine that the supply of the bonds that you need is limited and very expensive. One route would be to buy shorter maturity bonds but on a leveraged basis so that the P+L of this portfolio would match the P+L for the 30 year zero gilt (and, by design, the liability) as interest rates rose/fell. Eg £2 face amount of 20 year bonds. This is, in effect what LDI is doing and in nearly all market circumstances does what it is supposed to do and is a rational way to invest given current pension regulations.
The problems are that the pension funds had not got enough liquidity or credit lines to meet margin calls and I have some sympathy with them – the sort of moves were unprecedented. Who would have thought a UK Chancellor would be so stupid? In response, the BoE stepped in and all now runs smoothly.
In all the fuss about LDI strategies and “dangerous derivatives” “leverage” I think the real danger for pensions is being missed. The danger is the conceit that we can know what the liability actually is and how it will evolve (it’s a lot more complicated than my “single payment” example). We don’t and this is a problem…. but it is made worse by us pretending that we DO know what the liability is.
But what that proves is that the model is wrong – we are saying it can deliver what it canno0t be sure it can do – and too much depends on that for this risk to be taken
The risk is systemic
Thanks Clive. That is very helpful.
The problem for DB schemes has always been that the liability is not known and can only be estimated by actuarial modelling (that is, educated guesswork). So the amount of assets required is never known accurately. You might argue that this is such a big problem that DB pensions should not exist outside the state sector, but we are where we are.
It is a long-term problem, over years and decades, not days and weeks. So how are DC pension funds getting in a position where they are liable to margin calls that imperil their very existence?
Yes – the model is wrong. LDI investing is a reasonable answer but to the WRONG question.
If you ask the right question you will get to a more sustainable system…. along the Green Deal lines etc..
Agreed
Andrew,
That seems a very clear, illuminating and trenchant summary of the key issues. Clive’s further observation about LDIs seems to me to be partially in mitigation (I am less in the forgiving mood); but his real point, if I understand the intent, is here: “In all the fuss about LDI strategies and ‘dangerous derivatives’ ‘leverage’ I think the real danger for pensions is being missed. The danger is the conceit that we can know what the liability actually is and how it will evolve. …. ….. We don’t and this is a problem…. but it is made worse by us pretending that we DO know what the liability is.”
As Andrew points out: “The problem is that DB pension fund trustees have been encouraged to employ ‘liability-driven investing strategies’ (LDI) in recent years. Rather than simply managing their assets to produce a low-risk return, and seeking additional funding to cover gaps between the actuarial valuation of assets and liabilities.” If we look at major businesses with large pension funds (many still presumably including DBs), we will see that they have been running pension asset valuation shortfalls for years, and the responsible ones have been increasing their pension payments into the funds to repair the shortfalls (which for some companies at least, have been declining).
Richard’s comment in reply to Clive, goes to the heart of the underlying conceit and self-deception, that can be simply stated : “we are saying it can deliver what it cannot be sure it can do – and too much depends on that for this risk to be taken”. Part of the problem here is that the dangerous obscurity of the outcomes is buried under an exaggerated deference to professional calculation and the obscurity of the outcomes and their elusive probabilities; an approach to a problem which is itself dripping in latent risk.
We need to understand who has been driving the LDI use in recent years (when, for example did this become a material issue in pensions?); and what, exactly is the reason it has been pursued so aggressively, against more prudent strategies? Cui bono?
You were doing fine until you got to the “insufficient assets to pay the pensions” bit. The term “insolvent” is meaningless for a DB pension scheme, because ultimately its obligations are guaranteed by its sponsoring employer(s). The purpose of LDI was to match the duration of assets and liabilities so as to prevent employers having to cough up for unfunded future liabilities, However, for schemes that had deficits, the temptation to use leveraged LDI schemes to earn some money from interest rate spreads was too much to bear. So there’s quite a bit of leveraged interest rate exposure which is now unwinding as gilt yields rise. However, rising yields also mean the present value of liabilities falls, so overall the funding of DB schemes is improving. So there is NO risk of insolvency. None whatsoever. The insolvency risk was among the LDI scheme providers, who are asset managers like Blackrock and Legal & General.
Anyway, if a DB pension fund can’t meet its obligations as they fall due, its recourse is to its sponsoring employer(s), not the Bank of England. And if the employer becomes insolvent, the burden falls on other employers through the PPF levy.
Good to see you here: a shame you won’t engage in debate elsewhere
I read this after naming another comment about the obligation falling on the DB sponsor, but that is not what is happening: the state is supplying. So what we are seeing is market failure.
Your assumption of assets and liabilities matching is I think also wrong. They might, but cash is king, and they do not match at the same time, so insolvency can most definitely follow. Debits might equal credits bit that never proves solvency.
“the state is supplying.”
You are wrong Richard to suggest that the State is supply money to DB pension schemes..they are absolutely not. The market unwinding gilts and the by product of that is the impact on the term structure of interest rates and it is this that the BofE are trying to influence through this QE intervention..you infer there is a concern over the funding of DB schemes when there absolutely isn’t and this is not the reason for the BofE intervention.
Politely, I think this drivel
LDI investing left the funds with demands fir cash to provide collateral
The government intervened precisely to prevent those calls and that dies nit help penguin funds? Of course that was the purpose, whatever the delivery mechanism.
(incidentally, Richard,
where does the Govt. say the £65 billion come from which saved our pensions , last week ?
we know the tax cuts of £ 43 billion are unfunded
is the Govt secrectly supporting MMT ?
not another down the sofa source of funding. surely ?
It is QE – money creation by any other name, for the financial markets, as usual
Rob Gray makes the point about the BofE’s £65billion bung that has also intrigued me. Passing it off as ‘more QE’ surely doesn’t really explain it. For the bank to create the money from nothing a) is surely MMT and b) shows that the bank and the Treasury fully understand that, so that when the PM or chancellor denies a magic money tree he/she is lying, as Osborne was when imposing austerity whilst splashing out on HS2 (and lots more)
It’s all a reminder that the Tory party has dropped any pretence of governing for the whole country and is focusing on its raison d’etre of transferring wealth and power to its sponsors – big business, finance, and the Establishment.
PS Was Truss put in because Boris was getting soft after his Covid experience in hospital, and unlikely to fulfil his mandate to transfer the NHS to private ownership (and oblivion) in the next two years?
At a very basic level, markets can only ever provide “micro” solutions – because they depend on individual players operating in their own interests. The market fundamentalists then assert (without evidence) that in aggregate, all these individuals will deliver the best overall result. It is clearly nonsense as you have articulated frequently and clearly.
However, for many people this leap in understanding from micro to macro is difficult and it will always be a struggle to get a sensible policy…. but it is a struggle that we have to win; the world depends on it.
Correct
Good micro ≠ good macro
Clive Parry,
This is NOT what LDI funds do – they do not leverage short-dated bonds to match long-dates liabilities.
They leverage long-dated bonds to match long-dated liabilities! This means that rather than investing all of their money in low risk matching assets, they can use say 25% of their assets to match 100% of their liabilities (with 4x leverage) alluring the other 75% to be invested more freely to generate returns and close the funding gaps that must of these funds had/have.
The issue you identify is therefore not relevant.
Further, the most sophisticated LDI managers are able to use government bonds as collateral, and hence are not forced to sell gilts to raise cash, and some people claim.
Let;s be blunt: what they actually do is arbitrage risk in a way that has been shown to be non-sustainable
As a result, they cannot meet their promises
So, these funds are not viable without sponsor support (essential, they provided the contractual obligation to pay the pension) or the state (a coston everyone else)
Either way, as I have suggested, the market has failed and we need to move on from providing pensions in this way
What I was illustrating was that taking leveraged positions in gilts can give you the DV01 required to match the liability (wrt to rate moves)….. and this IS what LDI does.
That leverage allows buying different bonds that offer better value (shorter and non-gilts) or, indeed, other assets that they hope will deliver better returns.
My point was that LDI is not necessarily a reckless gamble….. although, not doubt some schemes are using it to load up on risk to close funding gaps.
Reading some of the comments now being made on this thread, I require to pinch myself that the BofE bothered to do anything at all. How to rationalise problems away; just like that! How smooth, how urbane, how slick; how easy. This is becoming like a game of musical chairs; depending on who you believe does not possess a chair when the music stops (different ones identified, depending on which source you read).
The problem, nevertheless sadly remains; because the problem was a matter of liquidity, not ‘matching’ balance sheet assets and liabilities. The BofE moved fast to stop a crisis developing, as one reprt suggested; in a ‘matter of hours’. Cash, Richard – as you say – is always King.
You should read the drivel I am deleting – almost all of which says there are no issues
Richard,
I’m afraid you have completely the wrong end of the stick. This is not a state bailout of pension funds. If anything, it is a state bailout of banks. Let me unpack this to show where you are going wrong.
First, your reply to my comment to Andrew.
“I read this after naming another comment about the obligation falling on the DB sponsor, but that is not what is happening: the state is supplying. So what we are seeing is market failure.”
The obligation DOES fall on the DB sponsor, and DB funds are in fact going to their sponsors for cash. See the explanation here. https://www.pensions-expert.com/Investment/Employers-face-contribution-calls-to-maintain-schemes-hedging-ratios?ct=true
The Bank of England’s exceptional intervention was not to bail out DB pension funds, but to provide liquidity to a desperately thin market. Had it not done so, bank funding costs would have increased sharply because of falling collateral values. There was also a risk that LDI scheme providers, who are not pension funds, would fail, though personally I don’t think the Bank would lose any sleep over that. But that would mean margin defaults for banks. Sir John Cunliffe’s written explanation to Mel Stride (Treasury Select Committee) said the Bank feared banks would liquidate gilt collateral, draining even more liquidity from an already distressed market and causing gilt prices to crash. The result could be a sudden catastrophic tightening of credit conditions for households and businesses. That’s why I say this is about banks, not pension funds. You can read Sir John’s explanation here. https://committees.parliament.uk/publications/30136/documents/174584/default/
“Your assumption of assets and liabilities matching is I think also wrong. They might, but cash is king, and they do not match at the same time, so insolvency can most definitely follow. Debits might equal credits bit that never proves solvency.”
DB funds go to considerable lengths to match the duration of assets and liabilities. It is why they are so extremely illiquid. And they hedge against mismatches.
Since the DB scheme can always tap its sponsors for liquidity, there is no risk of DB scheme insolvency. There is a risk of insolvency for the sponsoring corporations, but in this case the DB scheme would end up in the PPF.
See my comment to Martin Gilbert
This is total nonsense Frances and shows that a small knowledge of detail utterly fails to deliver understanding of a bigger picture
The funds were very definitely at risk of insolvency driven by short term cash demands. The intervention was aimed at stopping that and preventing the need for sponsor intervention that was politically exceptionally difficult. There are very few reports of those interventions: some, but not many.
Sure, the intervention was in the market but the whole intention was to ease pressure on funds by reducing collateral demands. You utterly miss the point, and are wrong about solvency in a crisis like this too. What is true 99% of the time is not in a crisis, that is why it is a crisis.
Your claims are wrong because you do not understand that in political economy we ask why things happen. You did economics which only asks what happened and as a result rarely gets the right answer.
Why have you decided not to post the comment I left containing the Bank of England’s press release?
Frances
As ever, you think the world revolves around you. I did not moderate your comment in thirty minutes and you complained.
I stopped working at 8. That is why. And that is my right.
When you learn to respect others, me included, try calling again.
I will now decide if your comment was worthy of posting, but you have set the bar pretty high now.
Richard
It’s nothing to do with “I finish work at 8”, is it, Richard? The FIRST comment I made on this post contained the Bank of England’s press release. You have not posted it. But you have posted and replied to my later comments.
EDITOR NOTE: THE REST OF THE COMMENT HAS BEEN DELETED AS IT WAS CORRECTLY MARKED AS SPAM IN THE FIRST INSTANCE
You are right: there was another comment. It was in spam as I blocked you on this site many years ago for persistent trolling of erroneous and repetitive arguments that added nothing to debate.
But, and I know this will shock you Frances, I do not spend my evenings looking for messages from you in my spam box. I am really sorry to disappoint you.
You got back on by using a classic troll technique, so now I will be banning you again
I found this article helpful to explain what has been going on. https://cpd071022.pensions-expert.com/
It explains (as some have said above) that increasing gilt yields is a good thing for pension funds in the long term, but in the short term the pension funds have a liquidity crunch because they are required to post collateral for their leveraged derivative positions. Even if they are in deficit, they still have plenty of assets, but don’t want to forced to sell in a falling market. And the Bank of England was forced to intervene to stop gilt prices falling too far in a market with few buyers. (That is, to prevent market failure.)
Sounds a little like Northern Rock all over again – long term illiquid assets falling in value, and insufficient liquid funds to meet short term liabilities.
Frances suggests it is all about banks and LDI providers, not pension funds. Is the press coverage getting this all wrong?
The overarching question is whether it is a good thing for pension funds to have highly leveraged derivative positions.
Thanks
“Frances suggests it is all about banks and LDI providers, not pension funds. Is the press coverage getting this all wrong?”
To put this plainly; even at face value, is that not a just a little like saying that the mortgage backed securities that were so critical in the US banking crash in 2007-8, was nothing to do with house mortgages?
Well put