ALM Stress : Pension Companies (Updated)
Large Deterioration in UK Pension Deficits
Update following the release of the May20 PPF Asset/Liability data (09 June 2020)
The PPF has published the consolidated position of Assets and Liabilities for the UK's 5,422 private sector defined benefit schemes. During the month of May the consolidated deficit increased by £48bn to £176bn.
Whilst the total value of assets increased by £24bn, as equity, corporate bond and gilt prices all rose, liabilities increased by £72bn as both gilt yields declined AND corporate bond spreads tightened, taking the discount factor for calculating liabilities lower (see further discussion on liabilities and discount factors in original post below).
In 2020 year to date the total deficit has increased by £165bn as 224 (22%) of the 1,030 schemes that were in surplus at year end 2019 have now moved into a deficit. Only 33% of the schemes are now in surplus (vs 45% at year end 2019).
When compared to previous episodes of market distress, the recent deterioration in the deficit is less bad than what it could have been (left chart below). This is due to ongoing changes in asset allocation, both away from equity into fixed income, and also more towards "risk free" gilts than high risk credits. As can be seen by the right chart, liabilities have tracked interest rates.....
.....but compared to previous instances of liability increases, assets have now gained in value as liabilities rose. Note the past gaps between gilt yields and asset values (green circles) compared to a smaller gap this time (blue circle):
However current asset allocations cannot recover past poor ALM choices for fixed promised benefits - the problem has been crystallised because long dated UK Gilt Real Yields have been deeply negative (30yrs at -2.20%) for some time now. Thus any investments into these instruments has guaranteed a loss over the life of the investment.
As can be seen by the increased deficits this year, the deficit has increased substantially despite and because of the huge rise in Gilts - current ALM positioning is just not right (i.e. the price movements of assets do not match changes to liabilities).
Which leads to the future and Central Bank Monetary Policy. The recent Band of England rate cuts and QE balance sheet expansion have directly led to the yawning deficits, through lower Gilt Real Yields and a support to tighten credit spreads.
In the same way that QE will continue to negatively impact bank balance sheets and profitability (see detailed explanation in ALM Stress: Banks), QE will cause irreparable damage to pension funds whose ALM has not matched known liabilities with proper assets. This will have serious ramifications to pension holders and their future consumption.
Update on the Covid19 impact on the Pension Company industry following the release of the Mar20 PPF Asset/Liability data 2020 (15 April 2020)
The table summarises the Total Assets and Liabilities for the UK private sector defined benefit pension schemes in the UK as at the end of March, i.e. after the decline in equity, widening in credit spreads and reduction in long dated gilt yields. In summary:
The £40bn asset loss was a 2% decline of total assets. This was LESS than the decline registered in the 4Q 2008, which is very likely to be because Gilt holding have performed much better in Mar20 than in the 4Q when Gilt yields rose. This will have mitigated the large losses from widening credit spreads and equity declines.
Contrary to what I expected, as long end Gilt yields declined by ~20bp, Total Pension Liabilities actually declined by £29bn. I had noted previous instances of Gilt yield declines and the associated rise in liabilities as the discount rate had declined. However in March pension companies have obviously INCREASED discount rates, and this will have been possible because although gilt yields declined, credit spreads widened, resulting in net higher yield.
The £40bn asset loss was therefore mitigated by the £29bn improvement in liabilities, resulting in a "mere" £11bn deterioration in ALM, taking the cumulative 1Q ALM position £125 worse off than year end 2019.
But here comes the conundrum for Central Banks. If they buy corporate bonds, as the Fed has now joined the ECB in doing so, and spreads tighten despite weakening credit fundamentals, then discount rates will decline and increase pension fund funding gaps. This of course assumes my central scenario of lower rates for longer, which has so far held even as equity has rebounded and spreads tightened. Of course, if Central Banks don't buy corporate bonds then there will be all sorts of other problems.
In summary, the summary of the "Outlook for Pension Funds" described below remains valid, with the exception that the deterioration of funding ratios to occur over a longer time period.
OUTLOOK FOR PENSION FUNDS: Impact of the market reaction to Covid19 pandemic on Pension Companies (30 March 2020)
Summary:
Expect pension funding ratios to deteriorate tremendously in March due to the toxic combination of a decline in long dated yields increasing the net present value of liabilities and due to a sell-off in asset values. In the UK, expect a substantial increase in the deficit of private sector defined benefit schemes.
A “lower rates for longer” environment will not provide any help to the pension industry in the near future. Indeed, any bull flattening of the yield curve that might arise from Central Bank QE and Forward Guidance policy measures will most worsen the financial imbalance.
Whilst such monetary policy might help in lifting asset values, the liability is likely to dwarf that benefit, increasing deficits further.
Increased deficits will drag on the valuation of companies who have pensions as an “on-balance” sheet liability.
With 30year Real Yields already negative in many countries (US -13bp, UK -207bp, Bund -100bp), likely hedging actions of government bond purchases whose pension is linked to inflation will make them crystallise a loss for the duration of that investment.
The Pension Industry ALM stress will keep long dated forward curves inverted and real yields of long dated risk-free assets negative as long as Central Banks limit the free float of long dated bonds through QE.
The 10s 30s curves should remain flatter for much longer than expected – this problem is not going to go away in the near future.
Introduction:
The 2020 sharp decline in bond yields will have an important impact on pension fund, insurance company and bank treasury balance sheets. This first note looks at the potential reverberation on Pension Companies that offer Defined Benefit policies, utilising the very timely data from the UK’s Pension Protection Fund (PPF link - https://www.ppf.co.uk/). The market impact described below for the UK Pension Industry will be similar across European and US pension funds, but in slightly different magnitudes principally due to differing discount rates used and different contractual obligations.
The net funding position of a pension company (penco) is simply the difference between the value of its’ assets and the net present value of its’ liabilities. Consider the two:
The value of a penco’s assets will change with the change in prices in its’ investments (equity, corporate and government bonds, as well as other alternative investments, e.g. hedge funds). With equity indices down anywhere between 20% and 30% this year, credit spreads widening and many hedge funds posting negative returns, capital gains from the government bond allocations will bring some welcome relief, albeit limited, to net asset values.
On the other side of the balance sheet, the net present value of the liabilities of a penco is simply the promised pension benefit in the future discounted by an interest rate (e.g. a long-term swap rate or government bond yield):
Net Present Value of a Pension Liability = Future Pension Liability (1 + Discount Rate) ^ n years
A smaller denominator due to a lower discount rate (due to the recent decline in yields) leads to a rise in a penco’s liability net present value. This was already a big issue last year as long-term yields declined, which has been exasperated by the further decline in 2020. The key issue is that the impact of lowering discount factors will have a larger impact on the future solvency of a penco than asset price capital gains. This is because the discount rate impacts ALL the liabilities, whilst asset price changes are not uniform against all the assets.
Example of the financial market impact on a Pension Company’s “Asset Liability Management” (ALM):
The UK Pension Protection Fund offers timely data on the asset and liability values of 5,422 pension schemes. The data and charts below come from their monthly PPF7800 report (monthly data good to Feb20).
The left chart shows the gradual rises in the Assets and Liabilities since 2006 and the net balance between the two, Despite the huge bull market in bonds and equities, the balance has hardly ever been positive since the GFC due to the rise in liabilities. Note the most recent volatility in the deficit, which is due to the volatility in the liabilities (which is due to long term interest rate fluctuations). The right chart shows the number of funds that have been in deficit on any given month and the number in surplus – there are consistently more funds in deficit.
The UK pencos learnt some lessons from the GFC and the huge deficits that arose from their over allocation in equities. Their products are fixed income in nature (offering an RPI linked fixed benefit), so naturally their deficits ballooned as long-term rates declined and equities did not match the increase in liabilities. In the last 10 years the industry undertook a large portfolio reallocation from equities into fixed income, which means on the whole their asset to liability portfolio should now be “more hedged” and better-balanced.
The recent data, however, shows that there still is a marked sensitivity of the net balance to long term yields, due to the latter’s impact on the discount factor on the Net Liabilities. The left chart shows the total net liabilities against the 30-year gilt yield (inverted), whilst the right-hand chart shows the net balance (i.e. assets – liabilities) vs the gilt yield. Note the recent volatility in the deficit which suggests ALM imbalances.
As mentioned before, the balance has fluctuated over the last 10 years despite a strong rally in the FTSE and the notable tightening in corporate and bank bond spreads. The latest PPF data is to the end of Feb20 and does not include March’s 28% decline in the FTSE 250 (it includes the “mere” 6.5% Feb decline) or March’s substantial widening of GBP Corporate Bond spreads (in Feb there was limited widening). Below right shows the recent performances of the FTSE250 and the ishares GBP Corp Bond Index with the dashed vertical line at end Fed20, when the latest PPF data is available. Clearly the March revaluation of equities and corporate bonds will negatively impact the UK pension industry’s asset values.
The below table from the PPF shows the monthly aggregate value of Assets and Liabilities and the Balance between the two, as well as the split between the schemes in deficit and in surplus. The extreme right column shows the change in the aggregate balance. So far this year, and before the large moves in March, the deficit of the pension system has increased by £114bn. But what could the deficit be at the end of March?
In the recent Aug-Dec 2018 FTSE250 correction of 17%, the assets of the penco industry declined by £53bn. That would assume a c. £85bn deterioration in assets with the most recent 28% decline of the Index. However, in that period Gilt yields rose slightly BUT credit spreads were virtually unchanged. In May19, when 30yr Gilt yields declined by 22bp (the same as March20), assets increased by £10bn. Taking that benefit vs the losses from corporate bonds, that would suggest a substantial asset deterioration for the month of March 2020.
During that 22bp decline in 30y Gilt yields in May 19, the NPV of liabilities increased by £77bn. Expect an increase in pension liabilities in March20.
Global Impact and implications:
Other defined benefit systems around the world will be suffering the exact same pain from the double whammy of increased liabilities lower risk assets, so expect announcements of deteriorating funding ratios which will have political and financial consequences:
For many companies, pension liabilities are “ON Balance Sheet” liabilities, which means that the companies with deficits will have a deterioration in their net capital employed position (net worth/equity).
A deterioration in net deficit positions could lead to further ALM de-risking and more fine tuning of asset allocation out of equity into more fixed income products.
Some countries might change payouts as contracts are less stringent (as the Dutch have already done post GFC). This will undoubtedly have an impact on consumption and consumer confidence.
Naturally, politicians and Central Bankers will want to see risk prices rebound, but they are powerless to react to force a rise in long end yields due to the implications on monetary policy and debt servicing (see a previous post : The premature end of low bond yields?).
A final comment should be made regarding the “Inflate away vs. write-off” argument that is debated to solve the existing state of global indebtedness. As can be seen from the pension fund numbers above, the writing-off of debt would lead to a Solvency problem for pension funds as their assets would decline and their deficits would soar – the same would obviously happen to people with defined contribution schemes who have invested in corporate and government bonds. Pensioners and those reaching a pensionable age would undoubtedly rebel against any government that would follow such a policy. Indeed, such action by any government would probably require the nationalisation of the pension industry – a huge cost that any government is unlikely to want to take (and probably one of the reasons why it has never been taken in the past).
Conclusion:
Expect pension funding ratios to deteriorate in March due to the toxic combination of a decline in long dated yields increasing the net present value of liabilities and due to a sell-off in asset values.
A “lower rates for longer” environment will not provide any help to the pension industry in the near future. Indeed, any bull flattening of the yield curve that might arise from Central Bank QE and Forward Guidance policy measures will most worsen the financial imbalance.
Whilst such monetary policy might help in lifting asset values, the liability is likely to dwarf that benefit, increasing deficits further.
Increased deficits will drag on the valuation of companies who have pensions as an “on-balance” sheet liability.
With 30year Real Yields already negative in many countries (US -13bp, UK -207bp, Bund -100bp), likely hedging actions of government bond purchases whose pension is linked to inflation will make them crystallise a loss for the duration of that investment.
The Pension Industry ALM stress will keep long dated forward curves inverted and real yields of long dated risk-free assets negative as long as Central Banks limit the free float of long dated bonds through QE.
The 10y to 30y part of government bond curves should remain flatter than expected for a long time – this problem is not going to go away in the near future.