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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”…
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….