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3) in a bizarre connection that doesn’t make much sense to me yet, pension funds need to report their obligations (as of today, how much do they owe how many lucky boomers in final salary pensions) in terms of the income available from gilts, yield.
I presume this regulation is to ensure they can always meet their obligation, since gilts/bonds are always the floor for any financial institution’s investments.
“Always”…
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I think you have a good understanding of it - I don't know any more about it than you, anyway.
I did listen to the podcast and it does clear a few things up, but as you say, there are some parts that I think they left out, particularly the link between pension funds having to report liabilities with respect to gilt yields, and how that caused the crisis. I found this government report which is very clear and detailed. Here's some extracts that I found useful:
15 Accounting standards FRS 17 and IAS 19, as introduced in the early 2000s, required pension scheme deficits to be reported on company balance sheets. They also required liabilities to be valued as a single figure using a discount rate based on the yield of bonds with at least an AA credit rating. A discount rate is a figure used to calculate the present-day costs of a future stream of payments. The future stream of payments is discounted by a rate reflecting the estimated cost of meeting them. For example, to pay £100 in ten years’ time, if you are confident that you can earn 4% interest each year, you need to invest around £67 now to do this.
16 The use of discount rates to calculate a present value of liabilities is also a feature of the valuations DB schemes are required to conduct at least every three years to check whether they are holding sufficient assets to meet their pension promises. If not, the trustees must prepare a ‘recovery plan’ (often including a schedule of contributions from the employer to reduce the deficit in the fund) and submit this to The Pensions Regulator (TPR). As part of the valuation, the trustees are required to calculate the present value of the scheme’s liabilities, using a discount rate that is chosen ‘prudently,’ taking account of the expected investment returns on the scheme’s assets and/or the yield on government or other high-quality bonds.
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20 The LDI model does not necessarily involve leverage: it is a way of managing assets and liabilities. However, the way it is used has become more leveraged over time. The reason is that between March 2006 and February 2021, most schemes were in deficit. If a scheme was fully funded (i.e. its assets equalled the present value of its liabilities) it could simply invest fully in gilts to match the interest rate sensitivity of its liabilities. However, this is expensive.
21 A scheme in deficit can use leveraged LDI to do this in a more capital efficient way, freeing up capital to invest in return-seeking assets. The following, over-simplified example, is an attempt to illustrate this: a scheme with liabilities of £100 and £90 in assets, could invest £90 in gilts. However, this would leave the remaining £10 in liabilities exposed to movements in interest rates and the fixed (and relatively low) rate of return on gilts would allow little progress in closing its deficit. By investing £50 in an LDI fund with two times leverage, the pension scheme could ‘hedge’ the interest rate risk of the full amount of its liabilities and invest its remaining £40 in ‘growth’ assets to close its deficit over time.
So that explains the link reporting to deficit in terms of bonds to the pension regulator, and the use of leveraged LDIs; the pension funds had a requirement to get out of deficit, which sounds somewhat sensible on the surface level - pension funds should be able to pay out - but led to systemic risk through pushing them towards leveraged LDIs. That leverage is the reason that collatoral needs to be posted, which caused the downward spiral in gilt prices.
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frankenbike
@t.o.
Here’s my go at it, I’m not an economist and don’t work in finance. I’m very happy to be educated further as to what I’ve got wrong:
1) final salary pension funds hold gilts (£1 trillion! Can’t remember but I think they said 60% of the pension fund assets)
2) gilt market values react to government actions.
3) in a bizarre connection that doesn’t make much sense to me yet, pension funds need to report their obligations (as of today, how much do they owe how many lucky boomers in final salary pensions) in terms of the income available from gilts, yield.
4) this yield increases when gilt market price decreases, so in a normal world, gilts going down today means pension funds can report that they will meet their future liabilities more easily - the % yield they have to use to report in has increased. It’s good for pension funds.
5) pension funds also hold gilts, but because they intend to hold them to maturity (nb I thought some gilts didn’t ever mature?) it doesn’t matter if the market value goes down today - if the face value is £100, but the market value today is £90, the pension fund shouldn’t care because it will get back the £100 on eventual maturity, from the government.
6) But LDIs. Pension funds also borrowed on short term markets to get more bonds (the £1tn), these are collateralised, ie mortgaged, so if the face value goes down eg to £90, the pension fund still owes the bank the original £100. So suddenly the pension funds do care if the face value goes down, because the banks can call their money in, quickly.
7) the banks would repossess the gilts and sell them, and this would tank the gilt market further. £1tn is a lot, it’s not just “the gilt market” that would tank so much as the UK economy.
That takes me to the end of episode 1….