Two arguments rage at the current time. Argument A states that it is only by hedging the mark-to-market value of its liabilities, that a defined benefit pension fund can have certainty that it will be able to pay all its pensions in full and on time. If it does not hedge, the pension fund runs the risk that those obligations will be too expensive to meet. The contrary position, Argument B, is that pension liabilities are very long-dated and do not need to be hedged on “a market-consistent basis” or at all; that such hedging is misconceived and driven by an accounting fiction.
These are not sterile, academic, debates. Argument A points to a failure to hedge as the root cause of growing deficits within defined benefit pension funds and urges those unhedged pension funds to consider their position carefully, before their remaining options are all bad. Argument B takes a far more sanguine position and declares there is no pensions crisis per se; rather, that hedging pension liabilities has driven, and is driving, a false market in interest rates that are historically low!
This parable takes the discussion away from the arcane arena of index-linked pension obligations and discount rates, and reframes it in rolling barley and cornfields farmed by a good man with a social conscience and a need to purchase cows.
Lots of them.
Once upon a time…
Once upon a time, there was a farmer. He grew corn and barley in a small field behind his house where he lived with his wife and their young son. Sweat dripped from his brow as he ploughed the fields and scattered good seed on the ground. The seasons came and went, and every year his corn and barley crop got bigger and better. He sold what he didn’t need and soon, he was making a handsome return on all the work he had put in.
The farmer bought more fields, grew more corn and more barley, and hired some strong and diligent farm workers to help with the harvest. The weather was favourable and predictable and his harvests were bountiful. As he grew more successful, the farmer hired still more labourers. Five years after he first planted his crops, the farmer had one hundred people working for him.
The farmer was a good man, and his workers were very loyal so he decided to show his appreciation. One day, he called all of his workers together and told them how much he valued them:
“I love how you all show up for work every day and put in all the hours that you do, and I am happy we make enough profit to pay you for your labour. But you won’t be able to work for ever. The day will come when you can no longer toil in the hot sun; when you will have earned the right to stop working and to spend quality time with your families.”
The farm workers looked at each other and nodded. The farmer was right.
“I am going to make sure”, the farmer continued, “that you can spend that time in comfort with more than enough to eat and warm clothes to wear in the winter. So, this is what I am going to do:
On the first day of every new year after you stop working for me, I am going to give you a cow. If you work for me for five years, I will give you three cows every year, from when you are aged 55, until the day that you die. And, if you work for me for 20 years, I promise to give you 12 cows every year after you stop working. You will drink fresh warm milk every morning and when you have enough cows, you can eat delicious roast beef too.”
The young farmhands were taken aback. This was extravagant generosity on the part of the farmer, and they knew it.
“All I ask of you”, said the farmer, “is that you contribute a small portion of your wages every month towards the cost of the cows that you will receive. I’ll take care of the rest.”
The people looked at each other with great happiness. They knew the farmer was a good man, but this was amazing. Now, they would be able to live happily when they stopped working.
The farmer, however, wasn’t finished. “And if, sadly, you should die, but your wife is still alive, I’ll give her cows until the end of her life too!”
This was too good to be true and some of the older farm hands had tears of gratitude in their eyes.
Suddenly, one of them stepped forward. He had a question.
“Sir”, he said nervously, “I thank you for your kindness. It is an honour to work for you. But, if I may ask, will you be giving us old, scrawny cows that are tired of life and that produce no milk?”
“Of course not”, said the farmer. “Every cow will be young and healthy. Even if you live for another thirty years after you have stopped working, I will give you the same quality of cow every year. Without fail. You have my word on it.”
“Thank you, Sir!” said the farm hand who had asked the question. It seemed an incredible promise – a lifetime’s supply of cows – but the farmer had never let them down, and he took him at his word. The man’s heart was filled with thankfulness.
Another labourer stepped forward. He was but nineteen and a slip of a lad.
“Sir”, he said. “Thank you for your generosity. But, we grow corn and barley here. We are not a dairy farm. Where will you get the cows?”
“Good question, Jack.” said the farmer. “I will buy the cows from the market on New Year’s Eve every year.”
“But how do you know that you will have enough money to buy all the cows?” asked Jack? The other farm workers began to murmur. Why so many questions? they asked themselves. If the farmer said he was going to buy the cows every year on New Year’s Eve, that was good enough for them.
The farmer was very patient with Jack. “As you know, I have done very well in my farming activities, he said. I have great wealth, and buying a few cows every year will not be a problem. Look, a cow costs £5. I could buy 1,000 cows this afternoon and give you ten each right now!”
The farm workers all cheered loudly. They clapped and shouted until they were hoarse. When they got home and told their family the good news, they clapped and cheered too.
They had thought things couldn’t get any better but, suddenly, life was better on the farm!
A few years later…
As the years passed, the farmer grew very wealthy indeed. He now had 3,000 people working for him. Some of the older farm workers had reached the age when they could stop working and receive their cows. So they did!
It was fantastic. Every year, a farm herder would bring the cows to the old farm workers in their houses. Right to their front door. Several farm workers had spent their entire adult lives working on The Farm. Old Bert had been there since he left school at aged 15. Forty years later when he stopped working, he began to receive 24 cows every year. He drank plenty of fresh milk and ate roast beef every single day. And he knew that if he died, his wife, Elsie, would continue to receive the cows!
In total, there were now 10,000 people who had worked on The Farm so far, and 7,000 of them had reached the magic age of 55. On average, they had worked on The Farm for ten years each, so six cows were due to every person (on average) that year. That meant the farmer had to deliver 42,000 cows to his ex-workers! A young, healthy, cow now cost £15 and the farmer had to find £630,000 in order to buy the cows that year.
It was a huge amount of money, and although the farmer was now running a very profitable corn and barley business, he couldn’t afford to expand any further. All the money that he had earmarked to invest in new harvesting machines was swallowed up by the cost of the cows.
When his farm manager told him the size of the bill, the farmer was dismayed. “I thought cows only cost £7 each!” he said.
“That was last year”, said the farm manager. “The price of cows has rocketed.”
“But why?” asked the farmer. “I remember when a cow cost £5.”
“There are plenty of reasons” said the farm manager “and none of them good. First, we had the Foot & Mouth outbreak across the country. We lost 20% of the herd then. And now, there are so many more countries around the world that can afford to eat beef and drink fresh milk. The emergence of the wealthy middle class, I believe it’s called. So, demand for good cows is soaring. The dairy and beef farmers are exporting cows to China, India and Brazil who are happy to pay up! When you made those promises to everyone ten years ago, Sir, there were loads of cows everywhere. Now, they are almost impossible to find! And the word on the street is that the price is going to keep rising.”
The farmer couldn’t see how the price of a cow could go any higher than £15.
The next year, the farmer had to deliver 54,000 cows to his ex-workers but now the price was £30 per cow. He had to find £1.62 million. This was rapidly becoming a nightmare. The farmer had started out with the best of intentions towards his farm workers, but he had never dreamed that a single cow could cost £30! Thirty pounds! That was insane. Of course, he had put some money aside to buy cows every year, but he had not anticipated using it up at this rate!
And his problems weren’t confined to that year’s bill for the cows. If this crazy pricing continued in future years, he would never be able to purchase another field or combine-harvester. Unlike Old MacDonald down the road who had just upgraded all his equipment! How had he managed that? The farmer prayed that the price of cows would fall. All his friends agreed. £30 was crazy. Everyone could remember when a cow cost £5. The price was bound to fall!
The year after that was terrible. The weather was too hot for too long and then it was too cold. His corn got the blight and his barley was a disaster. He had to plough the whole lot back into the ground.
Then his farm manager gave him more bad news. “You’re not going to like this, Sir. The cows cost £60 each this year! Apparently, you weren’t the only farmer to promise his workers healthy new cows every year for life. Farmer Green did the same and so did O’Leary. Word has it that even Johnson has promised to give his people cows and he has 100,000 workers! Not to mention all the others who worked for him over the years.”
The farmer was aghast. “But I thought the price of cows was going to fall, not double! Can we afford to buy the cows at that price??”
“Not unless we borrow the money. As you know, some of our investments have done well but they haven’t done as well as cow prices. And, in all honesty, unless the price of cows comes down fast, we are in for a tricky time. Over the next 50 years, we are going to have to buy well over a million young, healthy, cows! Of course, we could give the people tired, old, scrawny cows but that’s not what we promised them…”
The next year, the price of young, healthy, cows was £100 a head.
The farmer was beside himself. Although the perfect weather had made for a fantastic crop of barley and corn, the cow price debacle had ruined his business.
Old MacDonald had a farm
Then, one day, the farmer bumped into Old MacDonald and told him the sorry tale. Old Mac was very sympathetic, but then he asked the farmer a question:
“But surely you did the Royal Cow Transaction?!”
“What’s that?” asked the farmer.
“The Royal Cow Transaction? It’s a highly effective way of making sure that you will only ever pay £10 per cow. I only ever pay £10 per cow and not a penny more. Haven’t done for years.”
“£10 per cow! “That’s impossible!” exclaimed the farmer in disbelief.
“No, no!” said Old Mac. “Back when the cows cost £5 each, I did a Royal Cow Transaction which allowed me to only pay £10 a cow for the next 50 years. It’s called “Cow Driven Investing“. Of course, at the time, most people thought cows couldn’t cost more than £5 each and £10 was double the price. But, I realized that if Green, O’Leary, Johnson and you were also going to be buying millions of cows in the coming years, the price could very easily go up much further. And, if we got hit by the Great Barley Blight as we all did, I knew I would have problems meeting the enormous bill for cows every year! So I locked in the price. I never think about cows actually. Not my thing.”
“But how does the Royal Cow Transaction work?” asked the farmer in a daze. He felt a bit light-headed and wanted to sit down, but they were standing in a muddy field.
“Oh. Well, I already own all the cows I am going to need” said Old MacDonald. “I bought them from the Queen’s Beef & Dairy Farm. Her son looks after them on his organic farm down in Cornwall and every year his people just deliver them to me. Every year, I get the pick of the herd and it’s all set up for the next 50 years. We worked out an Annual Royal Cow Delivery Schedule ten years ago. It’s fantastic. I don’t really mind what happens to the price of cows. In fact, I hear they are £100 each now. Can you believe that? A hundred pounds each.”
Old MacDonald shook his head as he walked slowly down the lane as if to say “Wonders will never cease!”
The farmer was very angry. He remembered a conversation with a bloke in the Wheatsheaf many years ago. The chap was from out of town and, over a drink, mentioned that he knew someone who could arrange for the farmer to buy all the cows he would ever need at a pre-agreed price.
There were various ways to lock in the price of all future cow purchases, explained the man, depending on how certain the farmer wanted to be of delivering the cows. The two most commonly used were the Royal Cow Transaction and the Devonshire Cow Transaction:
The first option was for the farmer to buy all his cows from the Queen’s Beef & Dairy Farm in Cornwall. This was the safest and most expensive way to do it, for the Queen was the Ultimate Safe Supplier of Ultimate Cows!
“The Queen is the world’s foremost supplier of luxuriant, healthy cows and she can be completely relied upon to deliver them for the next 50 years. Her Majesty’s farms are 100% organic and her cows get a massage at 06:00 every morning. They only eat enhanced pure grass and drink Evian. There is no chance they will ever catch Foot and Mouth and they are healthier than most people can ever hope to be. They are amazing cows. Apparently the Queen’s son even reads to them at bedtime. These cows cost £10 each and you can lock in that price for a million cows over the next 50 years! This magnificent arrangement is the Royal Cow Transaction.”
The farmer’s other choice was to buy all his cows from Lord Devonshire’s Organic Dairy Farm. This was less expensive because Lord Devonshire’s cows ate normal grass and drank rainwater. They didn’t get a daily massage and no one read to them. Also, Lord Devonshire, although fabulously wealthy, was nowhere near as rich as the Queen and there was a small risk that over the 50 year timeframe, he might not be able to deliver the cows. “These cows cost £9 each and you can lock in that price for a million cows over the next 50 years! This, Sir, is the Devonshire Cow Transaction.”
“Love the Cow Transaction; but not at £9 a cow!”
The farmer loved the idea of locking in the price of a million cows. It would allow him to budget properly, manage cash flows on The Farm and concentrate on growing corn and barley. He could set aside enough to buy a million cows over the next fifty years and not have to worry about the price rising! He hadn’t realized such a thing was possible.
The farmer had thought about it for a while, but, after he spoke to his friends, they all laughed and told him that £9 was a ridiculous amount to pay for a cow and certainly not for the next 50 years! And as for £10 a cow, that was astronomical, even if it was to purchase the Ultimate Cow from the Ultimate Safe Supplier! Frankly, they said, £3 for a Royal Cow was more reasonable.
Looking back, the farmer couldn’t believe how things had turned out. His friends had been completely wrong about the price of cows. That was fair enough – they were just friends in a pub. But then he remembered that he had also paid a lot of money to Swash & Buckle, an elite firm of Cattle Advisers. After all, the farmer was a corn and barley man. What did he know about cattle? He had paid Swash & Buckle very good money and they had told him not to worry about the price of cows in the future – especially, they said, don’t worry about the cost of buying the Queen’s cows over the next 50 years! “Why would you care about those? It’s a nonsensical benchmark.”
The farmer hadn’t known what a “benchmark” was”, but he distinctly remembered being very relieved to hear that the future price of the Queen’s cows was of no concern today. He had even asked Swash & Buckle how they could be so certain that the price of cows was bound to fall to £3.
“Simple”, they had said. “£3 is the right price for a cow, and over time it always reverts to that price. Always.”
Swash & Buckle’s world view was that over the long term, cow prices would almost certainly fall to an average of £3. It was a sort of natural law of mean-reverting bovine agriculture pricing they had derived from historical data sets on cows.
That Christmas, the farmer had sent Swash & Buckle a lovely hamper full of good things to say “Thank you!”
When the farmer got back to the farm after his talk with Old Mac, he poured himself a large glass of English single malt whisky. Not only was The Farm struggling, it now transpired the entire situation had been completely avoidable! He needn’t have paid more than £9 or £10 a cow for the next 50 years!
“Here we are spending all our time trying to work out how to buy cows for people who don’t work here anymore, when we are supposed to be growing corn and barley” he thought to himself. It’s ironic. None of the hardworking, young farmhands we employ today can even afford to live anywhere near the farm; the old folk have bought up all the property with the money they made from selling all the cows we gave them!”
He raised his glass in a wistful toast to canny Old Mac and knocked it back in one.
“So now what do we do?” asked the farm manager. He was not feeling very well and his head ached. For the first time in his life, he understood that it was vital to have enough money to enter into some kind of Cow Transaction. And they did not.
“That’s the difficulty” said the farmer. “There are no cows left to buy, relative to the demand up and down the land. When was the last time you saw a cow? Apparently, almost every farmer in the country has promised nice, healthy, cows to their workers for the next fifty years and, given all that has happened with the Blight and the Storm and the Heatwave, and the Emerging Middle Class in China, demand for cows has never been higher. Some say there are only about 5 million left in total!”
“That still sounds like a lot of cows!” said the farm manager, hopefully.
“Not when you realize there are 1,000 farmers and, between us, we need to buy 1.25 Billion cows over the next 50 years. Who knows? Maybe the price will go even higher.
They talked late into the night, the farmer and his farm manager. They both knew there was a way out, a Plan B – it just wasn’t obvious.
The Farmer: the corporate sponsor of the pension scheme;
The Farm workers: the employees of the company;
A young, healthy, Cow: an inflation-proof pension payment;
Price of a Future Cow: The equivalent of a future monetary payment. A future cow and a future pension payment both have to be “bought”. The price of “safe money” in the future is determined by the price of a safe bond that pays out safe money in the future. A gilt is the safest bond to pay out safe money for the next 50 years. The price of a gilt today is the price of ensuring you will receive safe money in the future. You can buy safe future money now, or you can wait until the night before you need it, and hope you have accumulated enough to buy it. As with cows, that approach doesn’t always work.
The Queen: the Government;
A Queen’s Cow: an inflation-proof pension payment you can buy with the payment received from a government bond;
A Royal Cow Transaction: The purchase of a long-dated portfolio of index linked and nominal government bonds;
Other Cow Transactions (the Devonshire etc): Liability Driven Investment (LDI) transactions (incorporating varying degrees of security) that have similar characteristics to a portfolio of index linked and nominal government bonds;
Old MacDonald: A pension fund that has implemented a comprehensive risk management strategy;
Cow Insurance Corporation: An insurance company that bought all of Old MacDonald’s Cow Obligations from him so that he never had to think about cows ever again;
Swash & Buckle: A reputed firm of cattle advisers who told their clients not to lock in the cost of funding the pension scheme because “the price of index linked gilts and bonds is bound to fall“;
The Farmer’s friends: Bloggers, journalists and commentators who said hedging was a waste of time;
Bloke in the Wheatsheaf: An adviser who told all their clients to manage risk at all costs;
Other suppliers of young, healthy cows for fifty years: Long-dated, infrastructure projects and the like;
The Blight, Foot & Mouth Disease, Storms: The Global Financial Crisis, QE and Brexit.
Other blogs I have written