The Pensions Problem

Let’s talk about pensions. This blog is long and convoluted so I’m going to start it with a checklist to help you save some time if it isn’t relevant to you personally.

Read All About It!

I’ve had a few clients ask me about the pension scheme crisis which is all over the media currently. I have been able to put their mind at rest if their pension is managed by us.

All of our managed investment portfolios do not hold any of the financial instruments which are causing the current issues in the pensions world.

Hopefully the above statement will now put all of our clients minds at rest. All clients who have either a self invested pension savings plan or a self invested pension drawdown plan that we manage do not have to worry about the current liquidity issues that have threatened the existence of many pensions schemes. Mind at rest now? Good.

Now go and enjoy yourself and please don’t do that by reading any newspapers!

I Want To Understand These issues.

Read On.

I last blogged about why I do not hold Fixed Interest Securities* in our portfolios in 2016. You can re-read Tina (There is no alternative) here.

Back in 2015, I had previously explained why diversification was important (Owning investments that zig when other zag), and why I had chosen to invest only in small shares, medium shares and large shares along with cash deposits. I had chosen to forsake the opportunities offered to us by also investing in fixed interest securities* and commercial property. That blog was entitled The Egg, The Bread and The Sausage Roll.

Basics Please. * What is a Fixed Interest Security?

In a word it is a debt. A debt that has been packaged up for re-sale to investors.

Common names for these instruments are;

• Corporate Bonds – where the borrower is a company, normally a plc.
• Gilts – where the borrower is a Sovereign Government.

Incidentally, most of us have been on the borrowing side of a similar instrument; a simple domestic mortgage. If you have ever had an interest only mortgage, especially a fixed rate mortgage, then it is easier to understand other debt instruments like corporate bonds and government gilts. You borrow the money, you pay interest only, finally at the end of the term you repay the mortgage and you then own your property. A repayment mortgage works similarly, except you don’t need to repay the loan at the end as you repay a little every month throughout the term.

Corporate Bonds and Government Gilts are always interest only and are usually fixed in a couple of ways.

• The fixed level of annual interest payable by the borrower. Or in sexy borrowerspeak – the coupon given to the lender. The jargon used makes it sound like we are truly honoured to have had the opportunity to invest in Government debt!
• The fixed term.

There are a few Government issued Gilts that are not fixed rate, the coupon paid is linked to inflation. But overall they make up a small proportion Of all Gilts. They are a little more complicated but still perform in the same way as fixed coupon gilts do.

Terms usually vary from short to very long, Typically they are 10 years or longer. Pension schemes used to prefer 15 year terms, because at age 65 a pensioner could probably be seen out by the 15 year Gilt, leaving some eventual profit for an insurance company. (more below)

Never a lender or a borrower be!

Who buys these Fixed Interest instruments? Pensions Schemes mainly. Now you can probably see where the link is in this current crisis. The Government sells its debt to pension schemes and insurance companies who buy the debt. In normal times everything is hunky dory, but in times of stress something has to give.

How an Insurance Company Pension Annuity Works

The pensioner surrenders his pension life savings to the insurance company. The insurance company uses the bulk of those life savings to purchase a 15 year Government Gilt. This Fixed rate gilt then provides most of the pensioner’s annual annuity, the balance of the annuity is a gradual repayment of the pensioner’s savings accrued by retirement age. As the coupon payable is fixed, the risk to the insurance company has been passed on to the UK Government who “always pays its debts”.

Back in 1990 the annuity an insurance company could pay was about 10% of the pensioner’s life savings a year! It fell to just a couple of percent a year recently. With interest rates rising, who knows, annuities could become viable once again.

How a Final Salary Pension Scheme Works

Final Salary Pension Schemes are complex. They all operate on a basic promise. You pay into the scheme as does the sponsor. The sponsor also guarantees to pay out your pension for the rest of your life and that of your spouse when you reach retirement age. In the meantime they look after the investment of the money. In good times the sponsor doesn’t need to add as much in contributions, in bad times they must double, treble, quadruple, who knows? – the level of contributions that need to make up the shortfall to honour that promise. Thankfully not everyone retires at once and until a couple of decades ago there were as many fresh new joiners as there were pensioners.

Sponsors these days are mainly Governments for public sector employees. Individuals who worked in the private sector that benefitted from a final salary pension scheme and retired with 40 years service were very lucky indeed. Most private sector schemes, like Shell or Astra Zeneca have already closed to new members, most are in deficit now, meaning financially they do not have enough invested in the scheme to give the estimated full level of pensions to future and perhaps even existing pensioners.

Thousands of schemes have entered the Government sponsored Pension Protection Fund (PPF) like British Steel for example there is a paradox though, as the PPF is also permanently in deficit. If I was caught operating such a scheme as the PPF, the authorities would accuse me of running a giant Ponzi scheme. Falling stock markets and now rising Government Gilt yields have just made the liquidity issues (jargon for: not enough money to go around) much worse for all pension schemes that carry a fixed promise.

Pension Transfer

I believe it is clear now that the opportunity to transfer a paid-up final salary pension is now over for deferred scheme pensionerss. In simple terms the higher interest rate assumptions, the lower the transfer value offered. I’m happy to take questions on this if anyone is interested, but let’s stick to the current Pensions Crisis in this blog.

Where is the Crisis?

Let’s now bring this convoluted story all together now. Let’s use as an example a Gilt recently purchased by a pension scheme.

• 15 year Government Gilt
• £100,000 invested
• 2% Coupon

15 years from now there will be a return of the £100,000 originally invested and in the meantime the pension scheme will receive £2000 per year in interest. If interest rates remain the same – nothing will change.

Total return £30,000, plus the original £100,000 back

However interest rates rarely remain static. So imagine now that 2 years down the line (Today) it is possible for the same pension scheme to purchase a new Gilt. This time with a higher coupon as interest rates have risen.

• 13 year Government Gilt
• £100,000 invested
• 4% Coupon

The term to maturity is the same, Was 15, now 13 for both Gilts. The capital invested is the same, but the pension scheme will get twice the return. 4% rather than just 2%.

Total Return £52,000, plus the original £100,000 back. Since the 2% Gilt has already paid out £4,000 over the last two years, the future return now has reduced to £26,000.

What’s not to like about the freshly minted Gilt?

Hello John, Got a new Motor?

Our example pension scheme decides to flirt the first Gilt to the next buyer because it has no obligation to hang on to the 2% Gilt until maturity. Like with cars, there is a healthy second hand market out there. So where are the buyers for this second hand Gilt? Unsurprisingly they have all but disappeared totally, as they too would prefer a return of 4% on the new Gilt, rather than a return of just 2% on the first one over the same period. There will be offers once the limited new Gilt issue at 4% has run out, but expectations have changed with interest rates. The offers to buy come in and the maths is simple. Something that only gives half the interest is only worth half the price.

I must admit I have simplified this somewhat as you don’t need to pass any advanced financial exams in the near future. Suffice to say that on paper your £100,000 is now worth just £50,000. That shouldn’t be a problem as it will eventually all work out. Interest rates fluctuate and at some point interest rates could be back to just 2% and you will still get the same £100,000 back in 13 years time, irrespective of what interest rates are at maturity.

There is a huge paper loss but the £2000 is still coming in as income and the pension scheme can still afford to pay the pensioner. No Crisis really.

Mark to Market

This is where the zingy phrase “Mark to Market” raises its ugly head and where the current crisis lies. Financial Regulators don’t just sit on their hands and wait for financial disasters to occur on their watch anymore. They request endless reports on how financial firms are performing. Pension schemes are certainly not spared this vigilance especially since the collapse of the Maxwell Newspapers pension scheme.

I’ve just had to spend about 3 days piling through data for the latest new FCA report that is being sent to the Wealth Manager sector. They want stats on everything. On top of this new in depth report, our firm, along with all the banks and pension schemes that operate in our regulatory sector in the UK, have to report our levels of liquidity every 3 months. For us it is relatively simple. We are a small tightly run family firm and all client assets are owned by the individuals. We do not hold any client cash. Individuals savings are certainly not all pooled together under one firm umbrella. But consider the position of our example pension scheme, which like all final salary pension schemes does pool all members assets together. They have to report a 50% loss on this gilt and the rest of the Gilts they own currently which usually makes up the bulk of the pension scheme. This will trigger a liquidity event and perhaps send the scheme into insolvency on paper!

Congratulations if you are still with me.

What is the solution? If only our example pension scheme could just find a non-commercial Gilt buyer who would pay the full £100,000 and take ownership of the Gilt. Well this is the part where Andrew Bailey rides into town like a knight in rusty armour. Rusty because he should have taken action when his armour was still shining. Andrew heads up the Bank of England, his previous job was head of the Financial Conduct Authority. Personally I didn’t rate him highly in his previous role. He understands pensions though and he understands time needs to be bought. So the Bank of England steps in and takes ownership of the example Gilt, £100,000 goes to the pension scheme and the 3 month liquidity report sails through without disclosing the loss. Finally the Bank of England does what it is supposed to do, be a Bank of Last Resort.

Eventually the Bank of England’s gamble is that interest rates normalise back down to 2% and the Gilt can be sold back to pension schemes for the same £100,000. Who knows? Interest rates could normalise below 2% once again, say 1% and the BOE could make a profit. If none of that happens, the term of the Gilt ends, The Government then cancels the Gilt and returns the £100,000 to the BOE. It is just a waiting game.

Will the Government have £100,000 in 13 years time?

Currently the UK Government debt stands at about 3/4 of a Trillion Pounds. It was about 1/2 a Trillion prior to the Covid-19 political crisis. I will let you in on a secret -not a penny of it exists. When a Gilt matures the Government of the day simply cancel it and create another one for £100,000 with a 15 year term. The new buyer pays the old holder. The fictitious money goes around in a circle.

As the level of debt to the economy rises, the damage is done to the reputation of the UK and to the value of Sterling relative to other currencies; Unless other Governments around the world are playing the same game, which of course they are!

Questions?