A couple of weeks ago, a most respected financial journalist, Anthony Hilton, wrote an eloquent, scathing article in the Evening Standard. In it, he tore into what he regards as the fatally flawed regulatory and accounting regime that obliges defined benefit pension funds to “present value” their liabilities using a discount rate that is derived from the price of long-dated, inflation-linked market-consistent instruments. The difference between the present value of the pension fund’s liabilities and the market value of its assets, is known as the Deficit. In this environment of super-low real yields, deficits are soaring.
In response to Mr Hilton, I wrote a blog, Maybe the Earth isn’t flat, perhaps it’s round, comparing Mr Hilton’s arguments to those of the Flat Earth Society – an organisation dedicated to proving that, contrary to popular opinion, the earth is, in fact, flat.
Since then, something marvellous has happened: several other articles have appeared in discussion of this remarkably vexed debate, some in support of Anthony Hilton’s position, some against. Wading into the discussion, one of our industry’s prominent commentators, Dr Con Keating, has been particularly vocal, joining the attack on the management of the mark-to-market values of pension fund liabilities.
The marvellous thing I refer to, is that we now have both sides of The Argument set out in glorious, passionate, technicolour print and can get to work weighing it all up. This is important, because you can read the contributions to the debate and decide for yourself on their merits. This is no ordinary debate; the current state of the markets and some pension funds means it is vital to have a position you can defend. We are watching a train crash in slow motion and it’s terrible to behold.
I imagine this is reminiscent of the 17th century when someone came up with a thesis relating, say, to the laws of physics, and someone else knocked it down. The key, of course, was that public scrutiny was brought to bear and to assess the arguments. The fact that one side yelled whilst the other did not, or that each party was utterly convinced of their infallibility, was far from conclusive when it came to determining whose view won the day.
This setting out of the arguments for and against is the process by which, in a civilised society, we sift truth from fiction, facts from flights of fancy. I cannot think of a more important issue to be debated at the present time than this topic of pension fund risk management. On one view, hundreds of thousands of pension scheme members find themselves compromised because the trustees of their pension schemes were advised, or chose, not to hedge the mark-to-market value of the scheme’s liabilities. Others, because they were well advised, are now in possession of extremely valuable hedges that have performed as required – i.e., they rose in value as long-term real yields, and interest rates, fell.
Or, if you subscribe to the alternative, equally-strongly-held view, this entire situation (serious pension deficits; chronic underfunding of private and local government pension funds, stressed corporate sponsors,) is all down to an accounting fiction perpetrated by an industry which had, and has, malign intent to profit from it. This latter is a very serious charge and one that, in his closing comments, almost as an aside, Anthony Hilton made in his Evening Standard article. Con Keating takes things further, and uses stronger language.
Plainly, these charges need to be addressed.
Some of the exchanges are a bit charged, and you might think the protagonists are bitter enemies. Not so! We all respect each other enormously. But the gloves are off, and no quarter is given on this vital subject. Some think the earth is demonstrably flat, and will go to the gallows in defence of that premise. Others believe it to be round, and will happily drain the hemlock to the dregs, if needs be.
When the dust settles, we shall all go to the White Horse for a pint.
Let’s start with Con…
Con’s piece last week, Oblate Spheroids and Complete Balls sets out what he regards as the several flaws in my blog. Con does not pull his punches, (the clue is in his title) variously describing my thesis as “breathtakingly arrogant“, “repugnant” and “complete balls“. It’s strong stuff, but it’s very welcome. Because now, we can have a proper discussion.
The remainder of this blog attempts to analyse Con’s train of thought and, (full disclosure), to demonstrate conclusively that within the Venn Diagram of divergent perspectives on the subject of Pension Fund Liability Hedging & Risk Management, his reasoning belongs in the centre of the circle labelled “Really?”
Here are some FAQs to get the juices flowing:
Should pension funds have the objective of being fully funded?
We begin with the premise that pension funds should, in an ideal world, be fully-funded. In other words, be in possession of assets that, when they have earned a return, are sufficient to pay all the liabilities in full and on time. Without requiring further external financial support.
Con wholeheartedly disagrees, saying:
However, Dawid has also sneaked in the idea that full funding should be an objective.
I confess that this has me somewhat flummoxed. I mean, if Con doesn’t agree that achieving full-funding is a sensible idea for a pension fund, I am not entirely sure where to go next. It’s a bit like saying “The pilot has also sneaked in the idea that landing the plane should be an objective” or “the bank has also sneaked in the idea that paying the loan back should be an objective” or “the doctor has …” etc.
Yes. Of course the pension plan should be fully funded! What else should it be?
Everyone from the Queen of England to your London cabbie knows it’s a great idea for a pension fund to be fully-funded. As a concept it doesn’t really need to be snuck in.
Admittedly, Con may have a different definition of what it means to be fully-funded, but I cannot tell.
Con goes on:
The promise has never been: I promise to pay you 1.5% of your final salary for life in retirement, and I promise to maintain a fund or any other such nonsense. The promise was clear; it was the right to an income in retirement.
Whereas I was merely somewhat flummoxed, I am now also genuinely perplexed. Con appears to be taking issue with the very existence of pension funds. Not so much “The Earth is flat“; more, “Why is there even an Earth?” Presumably, that’s why he believes full-fundedness isn’t a sensible objective for a pension fund. If pension funds shouldn’t exist, why would you ensure they are funded in full or at all?
Of course, pension funds do exist and their entire purpose is make sure that pensions can and will be paid. That’s why they’re called pension funds.
Con’s Fifty Percent Rule
It gets odder. Con then explains that a fully-funded pension fund is only 50% likely to meet its obligations unless it has external support:
Why Dawid should specify full funding is not at all clear either, given that a fully-funded fund, were it unsupported, would have a fifty percent chance of failure prior to the discharge of all pensions.
As I understand it, the definition of being fully-funded is that you don’t need additional support to pay pensions due. If the sponsoring corporate becomes insolvent (a la BHS, Tata Steel, Woolworths, etc) the pension plan will still be able to pay out its liabilities. So where does a “fifty percent chance of failure” come from? How did Con calculate that? Is it a made up figure? Is he flipping a coin? Is he linking UK pensions to the individual rate of tax in Austria or the Central African Republic?
Con doesn’t say, and I leave you, the reader, to decide whether it is a sensible ambition for a pension fund to be fully-funded.
(I suspect that even Anthony Hilton believes it is a good idea for a pension fund to be fully-funded. He just disagrees on how that should be calculated.)
Moving right along, Con says:
“The arrogance of that next “deep understanding” sentence is, at first sight, breath-taking…”
Now, when someone accuses you of breathtaking arrogance, it is common courtesy to think long and hard about whether you have unwittingly overstepped the mark in the arena of confidence. We in the City are famously susceptible to that deadly sin. So, let’s take a look at what I said, and I quote:
“Some of us [prefer to] believe that a deep understanding of the complex relationship between assets and liabilities is the sole basis for an expectation of success.”
What is breathtakingly arrogant about that? The liabilities of a pension fund are index-linked, and very long-dated, and linked to changing life expectancy across multiple demographic cohorts. Self evidently, that makes them complicated. Working out what assets are required to pay the pension fund’s liabilities over many years is therefore very complicated. Thus, the relationship between the assets and the liabilities of a pension fund is a complex one. And yet, one that is essential to understand. Much like understanding the complex relationship between wind patterns, the physics of jet propulsion and varying rates of aircraft fuel consumption is kind of essential if you’re planning to fly a 747 from London to Shanghai. That’s not breathtakingly arrogant; it’s closer to common sense, I would have thought.
The Shock & Awe Technique
I am beginning to wonder whether, perhaps to save time, Con is simply adopting the Shock & Awe approach to dialogue. This is where you don’t really believe “The promise has never been: … I promise to maintain a fund or any other such nonsense” or that it’s “breathtakingly arrogant” to talk of a deep understanding of the asset/liabilities relationship, and you certainly don’t believe it’s a bad idea for a pension fund to be fully funded; no, you just fire Cruise missiles in the hope that your ideological enemies will be taken out. With Shock & Awe, the argument itself is irrelevant – your sole objective is to drop a kilo-tonne or two of high explosives onto anyone who opposes your thesis.
This interpretation is lent support when you dig out some of Con’s earlier writings. It is clear that he completely understands that defined benefit pension funds have a useful precautionary purpose and that they exist to facilitate savings. Indeed, that’s what Con says in this extract from his Long Term Finance and Investment published in May 2014 (Page 24):
So what does Con actually believe?
Hard to say. From what I can discern, Con believes that the pension promise is part of the corporate’s overall obligations and as such should not be hived off into a separate pension fund and treated as a standalone vehicle. Also, he doesn’t think the pension obligation should be treated as a long-dated index-linked promise that should be paid. He believes it is something entirely different although I cannot say exactly what.
Perhaps these pieces by Con will help as he explains:
The most complete synopsis of his world view as it pertains to managing pension fund liabilities is to be found in Pensions and Firm Value, a substantial piece Con published in June 2006. It is a must read, setting out, as it does, his beliefs and his deep antagonism towards managing pension fund liabilities on a mark-to-market basis.
Where to start our analysis? Let’s alight upon Con’s take on market prices:
Look; I am always impressed by chutzpah and when a chap, in effect, tells you he has redefined the concept of “market prices” as commonly understood, you have to take your hat off to him and wish him well.
What you cannot do, under any circumstances, is run your pension fund based upon his framework. You might as well plan to climb Everest in your socks and boxer shorts. Success is far from guaranteed.
But, did Con actually advise pension funds NOT to manage their liabilities using market consistent strategies or Liability Driven Investment (LDI)?
Yes. In The Great Pension Delusion (March 2011) Con described market consistent accounting as “fundamentally misconceived“:
And, in ai-CIO (25 September 2011) he maintained that LDI is “seriously misconceived” and it “appears to be ineffective“.
But surely Liability Driven Investment (LDI) has been effective?
Contrary to Con’s assertions, LDI has totally been effective. Every defined benefit pension plan that implemented LDI at literally any time since 2003, is significantly better off today than if they had bought the “seriously misconceived” line and abstained from hedging. Every single one! No exceptions.
Here, below, is a powerful graph of the asset class Con advised pension plans not to buy. It shows the increase in value of a safe, long-dated, index-linked asset (the 2% 2035 index-linked gilt) purchased in 2003 for a price of 100. Today, it is worth an incredible 276! That’s almost triple its value. For many pension funds, their LDI assets are the most valuable they possess.
On a risk adjusted basis, nothing comes close. We’re talking the Usain Bolt and Mo Farah of assets. They have been untouchable. The triple triple. Yes, I think we can agree that LDI has more than worked! If BHS had availed itself of this protection, it wouldn’t have mattered what Philip Green did.
Presumably, the Naysayers have finally thrown in the “LDI is Seriously Misconceived” towel and conceded that, not only has LDI worked, it has comprehensively blown all other alternative “risk management” strategies out of the water?
You would have thought so, but no. Not a bit of it. The Naysayers have become even more voluble, although now, they’re not shouting that interest rates “cannot be negative” or that the real yield is “set imminently to rise to 2% and beyond”. That, would be difficult. But the Naysayers are in a tricky spot. Having predicted that yields were certain to rise (due to mean reversion) and advised their clients that LDI was a waste of time, even dangerous, they are now experiencing what the behavioural experts describe as cognitive dissonance. That’s where you believe a premise, doctrine or mantra with all your heart and you write long and learned articles on your firmly held belief (e.g. the ineffectiveness of hedging the mark-to-market value of pension plan liabilities), only to find that you called it wrong and the evidence of that has grown until it is overwhelming. The resulting feeling of intense frustration as your world-view disintegrates, is “dissonant”. It is worth reading about the effects of cognitive dissonance. One recognised effect is the invention of new narratives in order to minimise the discomfort brought about by extreme dissonance.
Are we witnessing such effects even as we speak?
Seems so. As the long real yield falls to levels that were supposed to be “impossible”, the Naysayers have begun promoting the invidious and disingenuous idea that pensions consultants, investment banks and asset managers deliberately constructed a no-win framework in which pension schemes were obliged to measure their liabilities using gilt yields as a discount rate. This, they say, meant that pension schemes were forced to use ever-decreasing gilt yields to discount their liabilities, which, in turn, meant that the present value of those liabilities got larger, which, again, forced remaining, unhedged, pension schemes to buy gilts, which in turn pushed up the price of gilts, which kept the vicious cycle going until we reached the extremely high prices of long-dated gilts (and associated super-low yields) that we are experiencing today.
Team “Never Hedge The Liabilities!” go provocatively further. The pensions industry brought this about, they say, so that they could enrich themselves by giving lucrative advice to pension schemes. This is, essentially, Anthony Hilton’s central point but it is generally endorsed by Camp Naysayer:
Anthony Hilton – Our mad approach to pension fund deficits – Evening Standard – 14 September 2016
Is that true? Did you and the rest of the industry really come up with this market consistent construct for nefarious purposes of self-enrichment?
I almost cannot be bothered to dignify the question with an answer. The answer is no. Obviously not. No more than doctors invent sickness so they can cure it!
The “Rules” governing the reporting and measurement of pension fund liabilities were made in 2002 by the UK Accounting Standards Board and were designed to ensure that pension plan liabilities were measured consistently and prudently. Before that, it was a confusing mess. Whether you agree with them or not, the basic principles governing the accounting Rules were that defined benefit pension funds should take steps to ensure they can pay pensions even if the sponsoring corporate becomes insolvent, AND, that they should measure their liabilities using the price of safe, long-dated inflation-linked yields (since they have promised to pay long-dated inflation-linked amounts to former employees and it’s therefore crucial to measure those promises against their price in the market).
Those Rules (or some variant of them) have now been firmly in place for over a decade and every pension fund has had ample opportunity to ensure that it didn’t get caught short. Any pension fund that hasn’t hedged its liabilities, needs to ask its advisers hard questions. Heads up: in the US, the lawyers are softly murmuring the words “class action”. It’s just a murmur, but that’s how things start.
The truth is, the real yield fell for lots of cumulative reasons including the devastating Global Financial Crisis, the fact that, by purchasing long dated bonds, pension funds are in effect, collectively closing out a gargantuan short position in long-dated inflation linked cash flows (their pension obligations), and a side effect of Quantitative Easing. (This, of course, is precisely why you hedge. Because things happen that are way outside your control and that you cannot predict.) But, for the avoidance of doubt, whatever Con and the Naysayers allege, the industry of advisers, asset managers and service providers did not “set it all up”! That is, with respect, an absurd notion.
What some advisers have done for the last 12 years, given the Rules, was advise every pension fund Trustee or CIO that we met at every conference, dinner party, convention, gathering, book club, trustee meeting, in the school car park, online, and on the Number 36 bus, to “Please Hedge The Risk!”.
I even wrote a Rap Song, Kontrol Da VaR! to counter Con Lennon’s “Imagine there’s no hedging…”.
For over a decade, we have been pleading with pension funds to prepare for lower yields!
Easy to say, hard to prove!
Fair point; here’s some proof. These are some blogs I wrote in 2005. I called them Market Diaries.
The Market Diaries warned pension funds that “the real yield will fall as demand outstrips supply, so hedge now whilst stocks last!” I used a lot of metaphors to make my point, but that’s the gist of it.
Here is a sample blog – the one I wrote on 1st July 2005 when the real yield was 314 basis points (!!) above where it is today.
Many of my peers and contemporaries were making exactly the same point elsewhere. This state of affairs hasn’t just snuck up overnight. If you didn’t hedge because your adviser told you not to, you need to take him or her out for a coffee and have a long chat. An agenda might include: non-mean-reverting real yields, negative interest rates, sophisticated risk management, wasted opportunities and the PPF.
Come to think of it, we started telling everyone to hedge two years earlier in 2003!
There is a myth doing the rounds that it wasn’t possible for pension plans to implement a hedge until the year 2008. For the record, that’s incorrect. Some of us began expounding the merits of hedging pension scheme liabilities in 2002. Here’s an article I wrote thirteen years ago in October 2003. Friends Provident Pension Scheme read it and on 2 December 2003 hedged their liabilities’ sensitivity to the real yield to great effect.
But there has always been a vocal contingent of commentators who have maintained that The Market is out of kilter with reality; that it was simply a matter of time before long-dated real yields rose to their rightful level of 2% and much higher. They ascribed this “inevitable rise to higher normal levels” to the doctrine of “mean reversion”. Mean reversion is the idea that eventually, the day is saved as markets revert to some supposed “mean” or average. As such, they said, it made no sense to hedge the liabilities using derivatives, gilts, long dated bonds or other market sensitive instruments.
Here’s a genuine extract from formal written advice provided a few years ago to a mutual client by a very well-known, leading investment consultant who firmly advocated postponing the implementation of a much-needed liability hedge because, he advised, yields would shortly rise:
“It is inevitably a subjective judgement, and there is clearly significant scope for interest rates to diverge on the upside or downside relative to any expectation, but we suggest a 2.0% p.a. rate as a fair value assumption for the long term expected real return (which perhaps is modestly lower than could be justified on grounds of the most recent past).”
But the real yield did not mean revert to 2%?
That consultant’s view (that the real yield would likely rise from its level then of 0.50% to 2%), was widely held and relied upon by pension funds, and had catastrophic consequences for those who heeded it and didn’t hedge their liabilities’ sensitivity to a falling real yield.
Is it too late to implement a risk management strategy for our pension fund?
No. But it is undoubtedly late in the day, and any pension fund that hasn’t yet materially hedged the mark-to-market volatility of its liabilities and allocated its assets accordingly, is clearly in challenging territory, to say the least. But there is always hope. There is still time to take control of the pension fund’s assets and liabilities. My recommendation: find someone tomorrow who knows what they are talking about in this arena and ask them for some urgent risk management advice. Depending upon the circumstances, there is a lot that can still be done. As a general observation, whilst there is time, there is hope.
This debate is reaching fever pitch. Passion, agitation, hyperbole, satire, caricature, cognitive dissonance, forceful submissions and rebuttals abound. Personally, I am over the moon that some DB pension fund members had the good fortune to be members of plans at which their trustees, CIOs and managers heeded those early calls to implement highly effective hedges, and properly managed to prepare for the greatest assault on real yields and asset returns we have witnessed in our lifetime. But I am equally despondent that, through no fault of their own, there are thousands of members of other pension funds in a precarious position because, for one reason or another, their trustee boards never did put adequate hedges in place.
Con’s closing response in his assessment of my last blog, Perhaps the Earth isn’t flat; maybe it’s round, is full of knowing angst and fury, describing pension plans that have hedged as “polluters who have poisoned the pensions environment for the world at large“.
It’s not a lot of fun engaging in this debate. We are where we are and we all have the same goals. The sooner we lay down our cudgels and join forces so that we can combine our passion and experience, and harness our collective intention that everyone should receive a decent pension in retirement, the quicker we shall arrive at an answer. In the final analysis, it isn’t about us, and our obsessions with whether we are right or whether they are wrong. It’s about ensuring that an increasingly fragile Mrs Jones receives everything she needs in order to live a healthy, happy life in a place she calls home.