It's a mad,mad,mad,mad world

The sorry saga at BHS and Tata steel, amongst others, has brought the whole pension fund industry back into focus. The government has recently introduced a new bout of quantitative easing to help boost the economy, in theory. The unintended consequence of this action is to put further pressure on the pension industry.

Pension funds historically held a large portion of their assets in equities. This was entirely logical. As the global economy grows ever larger so should owning assets geared to the economy, to pay liabilities in the distant future. However, the pensions regulator saw it differently and encouraged investment funds to hold more bonds and less equities to better match “assets with liabilities”. So over the past 20 year’s pension funds have been reducing equity holdings and increasing their weightings in bonds.

The problem comes when bond prices continues to rise and yields fall, you need to own more bonds to meet those future liabilities. To hold more bond’s, you need greater amounts of cash from the sponsor, hence the fund goes into deficit if the cash is not forth coming.

We now have a situation where government bonds in the UK are joining the ever longer list of bonds that offer negative yields.  The government’s QE program is to buy bonds, the banks and pension funds hold the bulk of them but obviously can’t sell, in fact they need to buy more to meet the regulators desire to match assets with liabilities as yields fall. What is being created is a massive bond bubble, which can only end in tears, like all other bubbles.

Pension liabilities for public companies often make the press, BT is an example, Rolls Royce another, Tata which was once British steel another. Some of these companies were often once state owned and the pensions now seem generous, which has probably contributed to the funding problems they now face.

What is never given any news space is the state of the government’s own pension liabilities. Teachers, doctor’s, policemen, firemen all have pensions provided by the state. One can only imagine that the government must be facing the same funding issues that many public companies are facing. Perhaps this is why the government has introduced the compulsory funding of pensions by employees. One way to take pressure from the state pension is to force employers to create one for their employees. Which adds another layer of cost to the business, not to mention a huge amount of administrative red tape.

One final example of the madness of all of the current pension fund industry is the creation of the liability driven investment strategy (ldi). This is a structured product that enables pension funds to leverage their bond portfolio, to closer match liabilities with assets. If you leverage an asset you need margin, if the asset price moves against you, in this case bond prices fall, you need more margin. To meet those margin calls you need to sell assets. Prices fall further, you need to sell more, it becomes a vicious circle. Apparently the pension regulator sees this product as a good idea. One day the regulator is bound to encourage pension fund managers to move back into equities, but probably not before the bond market has collapsed. 

Posted on August 11, 2016 .