This is continued from our earlier post Pounds & Gilts. Recent reports indicate that UK pension funds are pressing the Bank of England for yet more bond buying to suppress yields to rescue them risky leveraged investments. The investments in question involve a type of derivative known as a “liability driven investment” or LDI. The BOE is resisting, as lower yields would come at the expense of a lower pound, pushing the losses onto a public already struggling with a loss of purchasing power.
The US should be paying close attention. It has serious pension funding problems of its own, and if it doesn’t put its house in order could be next.
This also raises the question: Are risky derivative products like these 2022’s answer to 2008’s subprime slime?
Straighten me out if I’m wrong, but based on media reports here the core problem appears to be leveraged investments in the pension funds, so called “liability driven investments” or “LDI”. The BOE has essentially thrown the funds a little more rope to give them time to extricate themselves from these risky synthetic investments. The BOE has put a time limit on this lifeline though, saying today it would end this week.
The problem was baked in from the beginning. These LDI aren’t actual assets as you and I know them, but derivatives structured to behave a certain way under certain conditions. One such condition being ultralow bond yields. What could go wrong?
In other words, the funds couldn’t find actual assets that would allow them to meet their obligations, so some were invented. This was never a realistic model. If I decide I need 12% returns to allow me to retire, I can’t just go out and create assets to order. I have to choose from what’s on the menu. If I can’t make it work, I have to increase my contributions or dial down my withdrawals.
The only difference with large institutional investment funds is that the financial industry may seize upon the opportunity to profit by creating fantasy investments to facilitate denial. They appear to present more value than the capital markets can offer by burying risk in places it’s not expected to be found.
Which only assures the scheme will grow until it is.
Now it appears the options are limited. The BOE can bail out the funds at the expense of the currency itself, or the bond market, or both, at risk of destroying the entire nation’s financial underpinnings. Or just leave the pension managers and their magic investment models to go out of business, and if anyone is to be bailed out, let it be the pensioners themselves. It would be a lot less expensive in the long run. Subsidizing bad decisions just assures more of the same.
Martin Hutchinson of True Blue Will Never Stain put up an depth review of the current UK situation:
The Bear’s Lair: Institutional stupidity threatens us all again
I don’t necessarily agree with all of Hutchinson’s conclusions (eg his support for the mini budget), but his knowledge of the situation and its historical context is beyond reproach. Highly recommended reading for anyone interested in this issue.
I’m under the impression that in the US the disappearance of defined benefits pensions in the private sector means that it is governmental pension schemes that will cause catastrophes here. iirc in CT the state supreme court has forbidden the government from retroactively adjusting the pension agreements made by politicians who knew the bill would come after they had left office. I think Illinois is in the worst shape but many other states are facing a pension crisis. and local governments too of course. it remains to be seen if the federal government eventually bails out state and local governments. they bailed out the banks, and then they bailed out individuals, so why not state and local governments? it’s just money, after all.
Thanks JK. Similar impression here.
I also wouldn’t automatically presume these pension funds have exposure to LDI like derivatives or that they’re otherwise leveraged (nor would I pretend to know they don’t).
But Hutchinson says the exposure of the UK funds is a legacy of EU regulations that they hadn’t gotten around to putting aside. Bailey however is lighting a fire under their backsides to do so.
i have no knowledge of leveraged schemes in gov pension funds except for calpers, which i believe just withdrew from a losing leveraged investment. but they all have unrealistic return assumptions and they’re all under-funded.
For sure … I just wanted to distinguish between the derivatives debacle and the more general pension fund problem, probably the bigger issue here in the US … especially since there’s so little being done about it. It’s perfectly understandable to not pull the rug out from under current and near retirees who’ve based years of decisions on them, but in many cases the programs haven’t even been rationalized for new employees.
They will ultimately have to follow a model more similar to the private sector. Even the federal government switched over back in the eighties from the generous defined benefit civil service system to a mixed model with a much lower defined benefit coupled with the 401k-like Thrift Savings Plan.