A paper describing a large problem at the heart of UK occupational pension provision
22 Apr 2004
The Redesign of Government Debt
Introduction
1. This short paper describes a large problem at the heart of UK occupational pension provision which has so far had no attention.The paper describes the damage which this problem is causing and gives recommendations.
The Problem
2. There is a widely held view, which could almost be described as a new dogma, that bonds and gilts provide the best match for pension liabilities and that equities do not. This dogma has had massive support from the new accounting standard, FRS17, which states that AA Corporate Bonds are the best proxy for pension liabilities, which must be evaluated using the actual yield on such securities.
3. In fact, neither bonds nor gilts are a close match for pension liabilities, for the following reasons:
i) Inflation – index-linked gilts (ILGs) are not available in 5% or 2.5% LPI format, so that inflation over those rates delivers inflationary returns from ILGs which are unnecessarily high. Pension purchasers of ILGs are therefore compelled to buy something which they do not need. Other forms of bonds or gilts do not match inflation at all.
The structure of ILGs also makes cash flow matching in a pension scheme difficult.
Inflation linked swaps are available, with a 0% floor and 5% cap if required, but not in very large size or without some counterparty risk.
ii) Deflation – ILG returns fall in deflationary times. The pensions provided by occupational pension schemes cannot.
Deflation generates enormous default risk for corporate debt, making it unsuitable as a match for pension liabilities in such circumstances.
When the threat of deflation became real a few years ago, the market for bulk annuities simply closed as the annuity providers could find no securities to match the obligations they were being asked to take on.
iii) Duration – the longest gilt is some 30 years at present. This is far too short to match the lifetime of pension obligations. Law Debenture for example is trustee of one closed pension scheme with a defunct employer where the payment of pensions peaks in 40 years time. Thereafter, pension payments steadily diminish. The duration of these pension liabilities is so long in relation to available securities that no annuity provider is even prepared to quote for taking on this business.
In many pension schemes the duration is shorter than this one, but it is still the case that the deferred members’ lives are longer than the available securities. This gives rise to re-investment risk as the annuity provider is having to quote today without any knowledge of the terms on which the proceeds of the bonds or gilts which they buy can be reinvested on maturity, in order to support the remaining pensions yet to be paid to those members who are still alive. Annuity providers compensate for this reinvestment risk by building in a large reserve to their initial pricing. This reserve is paid by any individual who buys an individual annuity, and by trustees who buy bulk annuities. The reserve is therefore a dead weight upon the national economy and on the individuals involved.
It has been suggested that the valuation basis of the Pension Protection Fund will be the yield on long dated gilts minus 50 basis points. If one is to infer that annuity providers price their annuities in the same way to allow for the re-investment risk, then an estimate of this deadweight on the economy can be made.
It is sometimes suggested that schemes should cash flow match rather than duration match. 30 year gilts help in cash flow matching scheme liabilities but clearly are much too short for payments that are 30 – 50 years away. Shifts in the yield curve can be sizeable and it is therefore important to have the tools to match long term liabilities.
iv) Longevity – there have been continuous improvements in life expectancy for the last century, and there is no sign of this levelling off, despite long held expectations that the limit must soon be reached. It is obviously more expensive to pay a pension to a recipient who lives longer than expected, particularly when low inflation means that the pension is not being devalued in real terms year by year. There are no securities available to match this particular risk.
It might be thought that matching salary growth is difficult for pension schemes, as in defined benefit (DB) pension schemes the size of the liability for active members is dependent on their final salary. Salary growth consistently exceeds the RPI by about 2 points per year. It is of course open to employers, subject to their trust deeds, to vary the definition of pensionable pay going forward. Also, RPI plus 2% is roughly what ILGs provide at the moment.
Consequences of the problem
4. The UK pensions sector, including both occupational and private pension provision, is estimated to be some £1 trillion. 80% of DB schemes have now closed, so they are moving more quickly towards the point when they will need to buy their benefits out. Yet the market for bulk annuities has suffered in the last 10 years from a steady withdrawal of companies prepared to sell them. There are now only two providers, Legal & General and the Prudential, whose appetite is only £250 million per year each, giving £500 million per year in aggregate. This is a pitifully low figure given the size of the market. They declare that the business is profitable for them, yet they are not prepared to raise their capacity, nor have other companies been tempted back into the market. The answer must be found in their need to balance profit against risk. Being unable to match inflation, deflation, duration or longevity they must limit the risks however attractive the profits.
5. Pension scheme trustees are similarly unable to find securities that match their liabilities. This has led to pension schemes vainly attempting to blend unsuitable securities into the right mix. The mix has to change as economic conditions alter, leading to supply and demand problems in the capital markets as big pension schemes facing the same problem attempt to move in the same direction at the same time. Necessary changes to the mix also lead to accusations of short termism. It is hard to rebut or avoid this in the absence of suitable long term securities.
6. In the absence of matching securities, companies are unable to price the pension promises they are making.
7. And the use of AA Corporate Bonds, which do not match the liabilities for the reasons given above, has introduced harmful volatility to company reporting, as the mismatch can lead to big swings in the solvency position from year to year.
8. The volatility in pension scheme solvency, in the price of annuities, and in the cost of pension provision (whether DB or defined contribution (DC)) has been equally harmful.
9. In the absence of a security which matches their liabilities, there are no ready means for trustees or DC plan members to evaluate quantitatively the risk they are running with what is necessarily a mismatched portfolio. There are therefore no measures for the “absolute risk” they are compelled to run, and management of the risk is correspondingly difficult. The absolute risk has been nevertheless the greatest source of risk and return for trustees and DC plan members.
10. These problems have contributed to the pervasive sense that there is a pensions crisis.
Investment banks.
11. In these respects, it must seem to anyone in the pensions sector, whether private or institutional, that they are facing a classic producer led capital market. The securities available are the ones that the issuers want to sell, not the ones that institutions like pension schemes, personal pension holders or annuity providers need to buy. Self interest leads investment banks to prefer to charge one fee in helping issuers place what they want to issue, and then to earn extra fees by repackaging the instruments for pension schemes.
12. Even with the recent development of the derivatives markets, repackaging is not the answer because it cannot cope with the duration mismatch, and the limited number of investment banks with suitable covenants makes it impossible for trustees to gain satisfactory diversification of the counterparty risk.
Why is this now an urgent problem?
13. 80% of Britain’s DB schemes have closed. This is a response by scheme sponsors to the greater risk and cost of such schemes, and to the sponsors’ unwillingness to carry such risk going forward. This has given the schemes therefore a more pressing need to match their liabilities, now that sponsors have withdrawn from, or limited, their role as underwriter.
14. The second reason for urgency is that new pension provision is increasingly DC. DC members are unable to minimise or manage their investment risks without a matching security.
The recommendation
15. Of the problems listed above in paragraph 3, the most difficult is duration. Even if corporates were to issue very long debt, history suggests that their covenant would not survive. One only has to look at the fate of big companies from the 1950’s, 1960’s and 1970’s to see that. The only issuer whose covenant would be trusted to survive for that length of time is the Government. Government also has a large enough borrowing need at present for meaningful quantities of such debt to be issued. Current interest rates are at a historic low so such a programme could commence on affordable terms for the Government.
16. If the new gilt debt were also to be issued in strippable form, this would enable annuity providers and pension schemes to cash flow match their obligations, and would therefore reduce their costs with consequent national benefits.
17. 2.5% and 5% LPI coupons on this new debt would be desirable, and so would a structure that put a floor under returns if deflation occurs.
18. The analysis in this paper might be taken to suggest that a new gilt of this type would be locked up by the holders. While some would be, particularly when insurance providers needed to match annuity obligations, we believe that there would be a secondary market. There were suggestions when ILGs were introduced that they would not be traded, but in fact there is a secondary market. This has been driven by changes to risk appetites, liability structures and economic conditions. We believe the same factors will create a secondary market for this new instrument.
19. The proposal made here does not deal with the longevity risk, but longevity is not the biggest unknown by a long way. If the inflation, deflation and duration risks can be managed in the way recommended then the longevity risk becomes more tolerable.
20. We acknowledge that the DMO’s objectives include maintaining a large and liquid debt market, which accommodates the requirements of a wide group of investors including insurance companies, pension schemes and overseas central banks and government agencies.
21. However, it is also important that the design of gilts recognises the importance of the key domestic pensions sector. We also recognise that the DMO has a duty to the tax payer to fund the Government’s deficit as clearly and efficiently as possible.
22. There is a national interest in doing so. Quite apart from the need to improve the capacity and pricing of the annuities market, private pension provision reduces the need for means tested benefits.
Conclusion
23. Government needs to borrow. Pension scheme and annuity providers need to lend. Inflation and deflation are risks that belong with Government, which has the tools to manage them. Longer gilts would make pension provision cheaper, which should be in the national interest. We propose that Government offers its new borrowing in terms that suit the lenders, as described above.
24. The proposal would benefit occupational pension provision, whether DB or DC, stakeholders and anyone who buys an annuity.
25. We would be happy to discuss this further with Government. We have already taken soundings on these ideas with investment banks and leading consulting actuaries, and would be happy to bring them forward for discussions if that would be helpful.
RFT
Pension Trusteeship
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