Who is to blame for the latest pensions debacle?
I suspect you have all heard about the gilt market’s impact on UK pension funds’ liability driven investment (LDI) strategies. Why did this meltdown happen and who is to blame?
I once worked in a bank, and sat through meetings in which the actuary reviewed its pension fund. He would provide a range of forecasts for the longevity of its members, inflation and the long-term returns on its assets, which resulted in an estimate of the fund’s surplus — or deficit — of assets over future liabilities.
I wondered then why the actuary was coming up with these estimates of future returns when he could simply look up the current price for the stock and bonds. Some years later I felt like the young man who had thought his father was an idiot, but as he reached middle age discovered that his father seemed to have become smarter.
The problem with showing an annual mark-to-market of assets and liabilities is that it brings short-term price volatility into the reckoning and that it may lead to poor decisions. Companies and pension fund trustees became obsessed with minimising this volatility. At this point the investment consultants who advise pension funds cooked up the LDI concept.
The idea was that a fund would estimate its future liability to pay out pensions by buying bonds or gilts to match those liabilities at maturity. This approach is flawed. Why not try to invest in assets that should produce a higher return than gilts over the long term, such as equities?
The answer lies in the willingness to swap a probably better but uncertain outcome from equities for the certainty of the redemption yield of government bonds and a desire to avoid annual mark to market swings. There can be quite sharp adverse swings in equity prices, just as we have seen in bonds, as interest rates rise. Yet bonds at least have a redemption value many years hence when the pensions are due for payment.
This story originally appeared on: Financial Times - Author:Terry Smith
