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Behavioural psychologists tell us that individuals and groups make local rather than global comparisons and have a bagful of party tricks to illustrate the resulting errors in decision and choice. They also show that groups of amateurs—such as trustees—will be highly focused on external rather than internal aspects in their decision process. “Is our action riskier or safer than the average?” “Has the regulator criticised or praised this action?” Moreover, nudges, such as British regulators’ emphasis on prudence, will be interpreted qualitatively: “We should be, and be seen to be, doing something safe and conservative to avoid criticism from our peers and stakeholders.” This is the hall of mirrors that surrounds liability-driven investment (LDI).
Lower interest rates increase the present value of pension liabilities, raising the apparent cost of pensions awarded, but this is an accounting convention. Interest rates are not a determinant of the ultimate amount of pension payable; length of service, inflation, salary, and much more—but not interest rates—determine that amount. It is an empirical and theoretical fact that companies in aggregate earn higher profits when interest rates are declining or low. The interest rate effects between pension scheme and company are polar opposites. When we hedge the interest-rate sensitivity of the scheme, we raise the interest-rate sensitivity of the company; in effect, this is gearing, rather than de-risking, the company. Thus hedging, the first step in an LDI strategy, is a local decision at the expense of the global.
In the UK, sponsors are the balance-of-cost underwriters of defined-benefit schemes. Assets remaining after the discharge of all liabilities are the sponsor’s property. Incidentally, this makes the sponsor a member of the scheme, to whom the trustees have duties.
Risk is the product of the likelihood of an event and its consequence—for pensions, the likelihood of sponsor insolvency and scheme funding condition at that time. Because of explicit UK legislation, the insolvency likelihood is a question solely of the sponsor’s ability to pay. In the US, where insolvency law is more debtor-friendly, the question of willingness may also arise. The order is important: unless the sponsor is insolvent, the level of funding is immaterial to pension holders. It means that risks within the scheme are only conditional risks to pension holders and as conditional risks they are much smaller than the unconditional risks to the sponsor. Hedging the unconditional risks within a scheme, if desired, should be done in the context of the sponsor company’s other exposures. It is obvious that many of these risks, beyond just interest rates, have positive effects for the sponsor, such as increasing longevity. There are few companies that do not profit from the increased demand of a larger population.
In Western free-market economies, it is an article of faith that regulators should not manage the likelihood of insolvency of any company. This leaves only the scheme’s funding position as a control variable and leads to such nonsense as Pension Protection Fund (PPF) CEO Alan Rubenstein’s recent utterance: “Funding trumps Covenant.” “Seatbelts trump Brakes” is an appropriate transposition of that battle cry. (I am indebted to Andrew Slater for this analogy.)
Asset-based regulation of schemes has added exorbitant costs to defined-benefit pensions, more than doubling true inflation and longevity cost increases. This has weakened the capital structure of sponsors and increased their likelihood of insolvency. It is evident from analysis of the values of assets and liabilities (as published by the PPF) of the aggregate of all schemes that all of the extra funding supplied to schemes has had no effect on scheme deficits. The expected result of LDI—closer covariance of assets and liabilities—has also failed to occur.
The interesting question is why it hasn’t worked. There are many reasons. Active resistance to the idea of hedging inflation exposures is one—more than 25% of schemes have sold all of their index-linked gilts, while the average holding has increased. Changes to scheme liabilities, through the alphabet soup of ETVs (Enhanced Transfer Values) and PIEs (Pension Income Exchange), closure to new members, and future accrual, are others. The basis risk in the hedging instruments used, swaps and derivatives, is relevant, but insufficient.
The overwhelming reason why it hasn’t worked is that liability valuations are driven by assumptions and choices made by trustees. These are subject to error, bias, and change. The magnitude of these effects is substantial—one UK scheme recently had a covenant review, which reported an increase in the likelihood of sponsor insolvency of, perhaps, 10 basis points, an increase in risk for this scheme of £1 million. The trustees chose to alter the discount rate to reflect this additional risk—this increased the present value of the scheme’s liabilities by £300 million. This is not prudence, it is reckless conservatism.
The problem with currently practiced LDI is that it is ineffective, costly, and counter-productive; a local solution in a global world. Let us not forget that hedging is one form of speculation.
Con Keating is the Head of Research at London-based BrightonRock Group.