Financial Engineering in Pension Funds- How's that working for you?
Pensions funds, who own more money and assets than God, still struggle to balance their assets and liabilities. Traditionally they achieved this in part by buying gilts to manage inflation/interest rate risk, and in part by investing for growth (e.g. buying equities). Some of the pension assets were used in purchasing gilts, thus reducing the money they had to spend on assets that might grow over time. After several centuries of doing this and following on from the 2008 CDO driven financial crisis, the banks came up with Liability Driven Investments as an alternative strategy. The pension funds would buy a hedge against inflation and interest rate changes, so they wouldn’t need to hold gilts any more. Better yet, and building on the expertise in the banks from their CDO lines of business, these LDIs would be margin traded, so the pension funds would only have to fund part of the cost of the LDI- the rest would be borrowed from the bank. The pension would then have all the money they had from what they spent on gilts plus the saving made from only funding the initial margin of the LDI - and this money could be invested in growth assets. This would improve the pension fund’s performance and their reported position on funding levels, risk and liquidity. For company pensions that were in deficit, it meant paying in less to fix this. This improved profit and reduced their accounting liability at the same time. LDIs are “Absolutely AAA, gold standard investments that don’t fluctuate”- maybe that quote was about CDOs, I may be confused.
In the last weeks the drop in value of gilts (perhaps caused by the mini-budget- but possibly caused by Putin, the Queen’s funeral or anything else you’d like to put in here) means that there have been margin calls on the pension funds as the value of the collateral the banks hold for the LDIs has reduced. The pension funds, because they don’t hold much cash, now have to sell assets quickly to pay the margin calls. These margin calls must be pretty significant, otherwise why would this trigger a Bank of England assessment that this threatens systemic failure to the UK economy? This would indicate that the degree of risk or leverage embedded within the LDI is also significant- which presumably came as a surprise to everyone. Not least the regulator (The Bank fo England?) who has allowed pension funds to use LDIs and by some accounts encouraged their use.
To avoid a fire sale of assets by pension funds destabilising the equity market and impacting the bond and FX market, the Bank of England now is spending billions to shore up gilt prices, thus reducing the margin calls and the risk of a fire sale. At the same time, hedge funds and traders can use this intervention to their advantage- cf George Soros and the fall out from the ERM. Once the market settles and we all "move on, lessons have been learned and we operate in a very different environment now”, the money will be recovered from the only source available- the UK Government and thus eventually the UK tax payer. So a profit making scheme for the banks and pension funds has losses socialised to the tax payer. And the risk of a pension liabilities exceeding the assets they have is presumably higher too- so pension holders will face this risk as well as a larger tax bill.
October 2022
In the last weeks the drop in value of gilts (perhaps caused by the mini-budget- but possibly caused by Putin, the Queen’s funeral or anything else you’d like to put in here) means that there have been margin calls on the pension funds as the value of the collateral the banks hold for the LDIs has reduced. The pension funds, because they don’t hold much cash, now have to sell assets quickly to pay the margin calls. These margin calls must be pretty significant, otherwise why would this trigger a Bank of England assessment that this threatens systemic failure to the UK economy? This would indicate that the degree of risk or leverage embedded within the LDI is also significant- which presumably came as a surprise to everyone. Not least the regulator (The Bank fo England?) who has allowed pension funds to use LDIs and by some accounts encouraged their use.
To avoid a fire sale of assets by pension funds destabilising the equity market and impacting the bond and FX market, the Bank of England now is spending billions to shore up gilt prices, thus reducing the margin calls and the risk of a fire sale. At the same time, hedge funds and traders can use this intervention to their advantage- cf George Soros and the fall out from the ERM. Once the market settles and we all "move on, lessons have been learned and we operate in a very different environment now”, the money will be recovered from the only source available- the UK Government and thus eventually the UK tax payer. So a profit making scheme for the banks and pension funds has losses socialised to the tax payer. And the risk of a pension liabilities exceeding the assets they have is presumably higher too- so pension holders will face this risk as well as a larger tax bill.
October 2022