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The upside of a gilt market crisis

It sounds reasonable to infer from recent events that UK pension schemes are in a pretty dark place. Their leverage has played a catalytic role in the Bank of England’s sequential emergency interventions. It might even be true of the unlucky few who were whipsawed by misbegotten derivative design and the BoE’s intervention.

But if you tilt your head just so, systemwide funding ratios have rarely looked better.

The present value of UK pension fund liabilities tend to be calculated with reference to long dated bond yields (from an accountancy, regulatory and management perspective). This is one of the founding principles on which LDI has been built. By taking economic exposure to assets which move in line with the present valuation of liabilities, so pension funds can reduce the volatility of their funding deficits.

Reducing deficit volatility is supposed to keep pensions out of the boardroom. It also facilitates the implementation of a recovery plan to take schemes to a fully-funded status (from their longstanding underfunded status). If successful, this course of action:

  • Improves pensioner security

  • Reduces risk-based levies due to the Pension Protection Fund

  • Reduces the need to gamble on favourable financial market returns (i.e., take investment risk)

  • Reduces the potential need for further cash injections on the part of the sponsor (sapping cash from other things that the employer might want to spend on, like business investment)

  • Reduces the threat that The Pensions Regulator might step in to interfere with the business (which it can if the deficit gets too wild)

But as well as wanting all these good things, pension fund trustees have – in my experience – leaned persistently bearish towards bonds. Taking out leverage on long-dated fixed income and increasing allocation to bonds from 28 per cent to 72 per cent over the last fifteen years might look like a funny way to express bearishness. But you can see this bearishness in the data: systemwide, schemes are underhedged. And as a result, rising long-dated yields improve their funding ratios while falling yields hurt their funding ratios.

For years this bearishness has been a source of enormous frustration for both schemes and their sponsors. Large additional sponsor contributions were provided quarter after quarter to schemes pretty much as a direct result of this (contemporaneously) misguided bearishness, and to help close the resultant scheme deficits.

As a rough guide as to how much rising yields helps the systemwide funding position, The Pensions Regulator has put some numbers together. It estimated in March 2021 that a “10 basis point rise in both nominal and real gilt yields increases the March 31, 2021 net funding position by £15.3bn, from £46.9bn to £62.2bn”.

Yields have risen by a lot more than 10bps.

The enormous jump in yields has delivered huge crunching strains on operational systems. If you needed T+0 liquidity to post cash collateral and your unitised growth assets settle on T+3 you’ve had a problem. Or if you’re taken leverage via levered pooled matching funds that are forced to delever, you’ve had a problem. Or if you’ve just got a lot of leveraged repo or interest rate swaps without huge amounts of excess collateral and your collateral value drops at the time that your P&L starts to stink and variation margin jumps, you’ve had a problem. But all of these problems concern the difficulty of retaining in place your hedges against the possibility that bond prices rise/ yields fall. Leaving aside the (important and large!) market impact of the Bank’s intervention, this possibility has not been much in evidence since the Chancellor presented his minibudget.

What has happened to pension fund deficits as yields rose? The present value of the liabilities have collapsed. Asset values have hardly flourished, but they have fallen less than the present value of liabilities. The net result is ballooning surpluses all around. According the PPF, around half of DB pension schemes had surpluses (valued as per section 179 of the Pensions Act 2004) at the end of the first quarter 2021; that proportion rose to 85 per cent by the end of September. The aggregate s179 funding ratio is now up at 135 per cent — by far and away the highest in the series history.

So all’s well that ends well for the average DB pension scheme?

A few caveats.

First, while the funding ratio will look insanely good for the typical fund against its own history, its asset allocation will look a complete mess. Illiquid assets that don’t get repriced with everything else will be a larger component than planned for or desired. Trying to reduce these in a hurry might be tricky. And good luck originating (or rolling over) infrastructure assets, private equity, private debt or venture capital for UK pension funds anytime soon.

Second, leverage is generally understood as being too high. The last couple of weeks has not been fun for schemes, even if it has brought better funding ratios. And while most large pensions schemes may feel proud of the governance framework that allowed them to survive the cash and collateral calls, they will likely want lower leverage in the future. This means unwinding synthetic duration positions taken in derivatives markets and purchasing duration in the physical market.

The timeframe for implementing the required duration profile using securities rather than derivatives is better measured in months than days. It requires huge sales of corporate bonds, equities and other growth assets, which might be tricky. But the pressure to act ahead of Friday’s close is so intense that derivative hedges are being taken off without the corresponding physical asset movements (that would add back duration, and lead to no net change in yields). The risk of falling gilt yields from here (that would increase the present value of liabilities, but not assets) is being transferred straight to sponsors’ balance sheets.

From a financial stability perspective this risk transfer is probably a satisfactory outcome, but it has seemed to result in rising long-dated bond yields. Continually rising gilt yields would be wonderful news to schemes from a mathematical funding ratio perspective, albeit perhaps less welcome to the rest of us.

Third, a funding ratio of 135 per cent sounds great (and is!) but – rather confusingly – there are a number of ways to value pension fund liabilities. The 135 per cent funding level refers to the ratio between scheme assets and s179 liabilities. And, as The Pension Regulator explains, a valuation under section 179 applies the PPF compensation levels to the valuation to “show whether the scheme would need to call on the PPF if the employer was to enter insolvency”. The Pensions Regulator issued a handy guide (PDF) to walk through the different valuation frameworks.

As the chart below shows, the s179 (labelled ‘PPF’) liability valuation is always the lowest (and so the funding ratio using this measure will be the best). All of these valuation measures though will all be related to differing degrees to the level of long-dated bond yields.

What does this mean? It means that a 135 per cent s179 funding ratio might still leave a pension fund underfunded on a buy-out or even a self-sufficiency basis. Over the past ten years full buy-out liability valuations have averaged 141 per cent of s179 liabilities. So not quite home and dry.

But DB pension funds might actually be in a better place than you might’ve thought. Unless (paradoxically) the gilt market rallies.

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