A tricky balancing act
It has been said that one of the most overused words on the UK pension scene over last few years has been found to be ‘crisis’, but that does not mean a crisis does not exist. Indeed the word ‘crisis’ has never seemed more appropriate than at the moment, and it looks as though it will get worse before it gets better.
We have been reminded as never before that there are two main items on the pensions balance sheet. We have liabilities as well as assets and it does not matter what happens to a scheme’s assets if liabilities are increasing at a faster rate. Even funds that thought they had immunised themselves have found out that they had not quite done so. In fact, almost the whole market has been caught out, and the reason for this is essentially the imbalance of supply and demand in the UK bond market. The UK government has issued only a very small supply of very long (50-year) traditional and index-linked bonds, but has actively encouraged funds to use the long bond rate as a basis for discounting liabilities.
So is it any surprise that, although real interest rates on government bonds have fallen to extraordinarily low levels everywhere in the world, real interest rates on UK long-dated government bonds (gilts) have fallen still further. In fact, in a few cases they have now fallen to less than half the level available in the US.
Some people are saying this is as bad as the tech bubble experienced at the turn of the century. But why has it happened and what will break it?
There are a number of pressures on pension funds and it seems to be worse in the UK than the rest of Europe.
Under pressure from the regulator, companies are trying to reduce fund deficits, and this often results in higher contributions and pressure on the trustees to match assets more closely to liabilities to reduce future cash calls. In addition, using new accounting standards FRS17 and IAS19, accountants have pushed funds to mark to market and discount liabilities at market rates.
So funds which were over exposed to equities are continuing to be encouraged to switch ever more of their assets into bonds and swaps. However, there appear to be rather more buyers than sellers, so we are seeing what amounts to a wall of money chasing a very limited supply of long-dated gilts. This is pushing returns to pitifully low levels - around 0.% on the government’s 50-year index linker. In a sane world without these (artificial) pressures, would funds really want to buy ultra-long gilts on such terms?
Since most funds still have more equities than bonds and even the bonds that funds hold are usually too short in maturity, by discounting future liabilities at such low interest rates the size of deficits has inflated. Higher equity markets just rub salt into the wound, but what really hurts is that low long bond yields are a large contributor to the discount rates used to estimate deficits by the UK’s new Pension Protection Fund (PPF). Thus lower yields will force many funds to make even higher payments under the risk-based PPF levy.
The higher deficits will, of course, then push funds into trying to buy even more bonds at ever lower yields, thus making the problem even worse. Of course investment banks say ‘not to worry’, buy swaps instead; but what do they base the price of swaps on – why, long-dated government bonds of course.
So although the UK pension crisis may initially have been caused by rising longevity and excessive reliance on overvalued equities, the current long bond market bubble has made this problem much worse. As a result, many companies are cutting future pension provision quite aggressively. A few companies are even cutting existing pension provision to help balance the books.
It is therefore no surprise to see pressure on the UK’s Debt Management Office to issue more very long gilts and more very long-dated index-linked securities. The 50-year gilt had a real yield (after inflation) of just 0.45% by the middle of January, indeed yields touched as little as 0.38% at one point. All this on a bond that yielded 1.1% when it was issued in September 2005 and was planned to yield 1.25% a month earlier. At this rate investors will shortly be paying the government for the privilege of being allowed to hold the security.
The government is considering the pleas to issue more long gilts: but will they do so quickly enough? Apparently the planned issue next year will be significantly larger than the £17.9bn (e26bn) in 2005-06. But even double may not be enough. However, the price by then should mean the government will have the deal of the century. It is not often that industry encourages governments to go deeper into debt but at the moment it seems the only answer. It is just a pity the pensions industry can not seem to come up with a better answer.