• Edward Ballsdon

No V for pensions

I was taken aback by the fact that 7 times more people read my post on how market reactions to Covid19 would impact Banks compared to how it would affect Pension Companies. I found this strange as everyone has a pension in one shape or form, whilst much fewer people are impacted by a bank (not everyone has a loan or saving with them).


BANKS :


In my 27th April blog I highlighted that banks would be negatively impacted in three ways:


  1. Asset quality would deteriorate, and a rise in Non-Performing Loans would require reserves which would shrink profitability.

  2. Low yields for a very long time, which together with tight credit spreads (both a consequence of QE), would cause a further contraction of Net Interest Income Margins.

  3. Investment Income, a large driver of profitability post crisis, would collapse and disappear as yield curves would remain low and flat for a very long time.

These negative impacts have been easy to spot in the 1H20 bank results that have been posted since that blog, even though the extent of the long term damage has been somewhat masked in some cases by large (and unsustainable) trading profits.


The stock market has not rewarded holders of bank equity – the rebound off the lows has been poor (below SPX Banks and Eurostoxx Banks Indices).



PENSION COMPANIES:


The lesser read posting on the Pension industry, initially published on the 30th March and updated in June, highlighted the negative impact of financial markets on the pension industry. Crucially this negative impact stems from the move to a low flat yield curve with tight credit spreads, which has an impact of INCREASING liabilities more than any incremental gain made from financial asset appreciations.


This will affect anyone who will rely on a pension, be it a defined benefit or defined contribution (liabilities rise for both), or a mere government pension.


I used the timely and detailed data released by the UK’s Pension Protection Fund (PPF) to highlight the power of low flat yield curves in widening the pension deficits. The most recent data has been released for the 5,422 defined benefit schemes covered by the PPF, which shows their funding situation as at the end of July 2020:


  • The aggregate balance of all schemes reached £200bn, as LIABILITIES grew more than ASSETS (top left)

  • 688 schemes have moved from a surplus to a deficit this year – there are now 3,685 pension funds with a deficit (totalling £306bn) which represents 68% of all schemes (top right and bottom right)

Source : PPF


This has occurred despite large scale fixed income hedging over the last couple of years. Worryingly, long dated Gilt REAL YIELDS have now reached -2.50%, showing that all new investments made by pension funds into Nominal or Inflation Linked Gilts ARE NOW EXPECTED TO LOSE THAT PENSION FUND'S MONEY.


In other words, pensioners being paid out today are being subsidised by future pensioners.


GOING FORWARD


This problem cannot be resolved with funky Asset Liability Management - this has already been tried, which is why the Pension Industry finds itself in this situation today. It would take substantial bets on assets that are not linked to liabilities to get back to par, but that would lead to the risks of higher portfolio volatility and risks that a pension fund should simply not have to bear (look at impact of equity on PFs in last crashes).


The only real risk free solution to close the pension deficit is through a large continuous cash injection by the pension provider. For a


  • defined benefit plan, this will mean a protracted cashflow strain on the company sponsor, which would also be negative for shareholders and bond holders. This for sure is NOT priced into some equity stocks where the pension is an on balance sheet liability.

  • defined contribution policy, there will be a requirement for higher household savings going forward to build a larger pension pot than what was once required.

  • government pension plan……either a cut in other governmental services or higher budget deficits.

As in many cases of financial excess and investment mismanagement, the maths of the current situation is really quite simple and clear (if you know where to look). However, at the same time the solution is very difficult indeed.


No doubt the can will continue to be kicked down the road for the time being, but watch out if you are relying on living off a pension in the future. Which of course comes back to why I thought the pension article would be read by more people than the article on banks!


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