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ALTIF Transcripts; The Great Pension Fund Panic of 2022

The market panic that followed Kwasi Kwarteng’s mini budget last month has been blamed on pension funds doing something called LDI. But what is this strange practice, what is its purpose, and how has it led to a £65bn meltdown in the pensions market? Neil and Jonathan talk to pensions expert (and grand wizard of LDI) John Ralfe about the fallout and whether Neil, as a pensioner, should be worried.

Presented by Jonathan Ford and Neil Collins.

With John Ralfe.

Produced and edited by Nick Hilton for Podot.

Hosted on Acast. See acast.com/privacy for more information.

Jonathan Ford 00:06

Hello, and welcome to a long time in finance with Jonathan Ford and Neil Collins, in partnership with briefcase dot news, the service that brings intelligent curation and analysis to your media monitoring. To some, the market turmoil that followed Kwasi Kwarteng Mini budget was an uncomfortable reminder of the financial crisis, I know you’ve got some pretty strong feelings about what happened next.

Neil Collins 00:33

And you knew, I certainly do have strong feelings because the Bank of England realised pretty quickly that it stood on the edge of the abyss, when there were no buyers for UK government debt, something which is almost unprecedented, they realised that they had to do something and they had to do it quickly. And they had to do it big. So they said, right, we’re prepared to support the market with 65 billion pounds worth of cash. Now, why was that necessary?

Jonathan Ford 01:05

Yeah. And it leaves this big question, what the hell did just happen? And is it a sign of deep disturbance in the market? And when should we be worried about our pension schemes? So to unpick these naughty questions, without descending into impenetrable jargon, we’re joined by John Ralph, a pension consultant. Now, more than any other pension expert, John helped to create this concept of LDI, which stands I think, for liability driven investment. When in 2001, he was the head of corporate finance at boots, and he restructured their pension scheme, taking them out of equities and putting all the proceeds into bonds. So welcome, John. Before we get into what happened in the last few days, we should start with a simple definition of what liability driven investment is and what it’s designed to do, and what role it played in the crisis.

John Ralfe 01:57

Hello, and the (inaudible) don’t like the term liability driven investment, and I never use… I think I’ve been proved right. In the events of the last few days, and before we get down into the detail, be very clear that we would not have seen the apocalyptic headlines, we would have not seen the UK financial system and the edge of meltdown, Bank of England, having to intervene if pension funds activities in the financial markets had been hedging. If they had all been hedging, in other words, matching your assets and liabilities, there would have been a little local difficulty. But the reason why we’ve been on the verge of a meltdown is because some pension schemes, a lot of pension schemes or most pension schemes, and I genuinely don’t know, which that is, they weren’t hedging. They weren’t matching assets and liabilities. They were speculating big time.

Jonathan Ford 02:49

But let’s go back to what you did in 2001. So you’re saying that that wasn’t LDI? You were basically hedging your pension fund. Can you tell us what you did?

John Ralfe 02:58

Well, what we did, I was in charge of the Treasury Department, I knew nothing about pensions that was done by somebody else on a wet Friday afternoon. I was co-opted into a working party on pensions, and suddenly realised that Boots is a big company, had a big pension scheme. And what we had was a commitment to pay pensions going forward for 40 years, and these pensions were inflation-linked, it was a huge liability – wasn’t a liability that I had gone out and created, I hadn’t gone out and borrow lots of money. But we had this huge liability. Worse than that, what we had on the asset side of the balance sheet were pretty much equities. So you’ve got huge liabilities on one side, you’ve got equities on the other side, the value of the equities and the value of the pension liabilities do not move in line, the company is standing behind the pension scheme on the hook to make good any deficits. So the pension scheme is an unconsolidated subsidiary of the parent. The job of risk management should be done by the company, not by, you know, amateur trustees on a wet Friday afternoon. So what did we do, we set out over a period of 15-18 months to match the assets and liabilities. So we very quietly sold the equities, and we bought matching long dated AAA AAA bonds, things like the World Bank and the Nordic investment bank, and index linked bonds. Having done that, it would have been a buy and hold strategy, as you said… Very simple. Very boring. What are the advantages of that risk management? Reduces risk for shareholders. They’re not on the hook to fund these unexpected deficit contributions. It’s good for individual pension scheme members because if the company goes bust, it’s less likely that the value of the assets in the pension scheme won’t pay out their pensions. And if you look at the macro level, it was good for the financial system as a whole because to the extent that other companies did it, you’re taking the risk out of the financial system, you’re reducing the leverage of the whole financial system.

Neil Collins 05:08

John, that’s very helpful. Why have we got to the position today where what you might describe as maybe ‘son of LDI’ has produced this crisis?

John Ralfe 05:21

Well, I’ve in the last week or so, Neil, coined the phrase LLDI, leveraged liability driven investment. That has allowed companies, through their pension schemes, not properly reported to shareholders, not properly reported to the pension regulator, not properly included in the reported accounts, effectively to go out and borrow. But what that allowed companies to do is apparently, take risk out of their pension scheme, because they’ve matched the liability side of the balance sheet. But at the same time, bingo, they’re still continuing to invest in equities, private equity, hedge funds, all sorts of things.

Jonathan Ford 06:01

So this is a sort of have-your-cake-and-eat-it situation. Basically, what they’re doing – Pension funds are not supposed to borrow to invest. So they are basically using derivatives to basically increase their exposure to gilt and long-term bonds, while at the same time investing in riskier assets.

John Ralfe 06:22

Exactly, exactly. Now, there’s one quite important link in the chain, Boots matched assets and liabilities. 100% bonds 75% fixed, 25% inflation linked, that wasn’t enough, we’ve got you know, as much as the market could give us. So what did we do? We did the first interest rate swaps in 2002. The first one was 50 million quid for 18 years. So what we were doing was tweaking the basic strategy with interest rate swaps, those swaps designed as better risk management. And that was all…

Jonathan Ford 06:53

when you’re talking about swaps here, just so people understand what’s going on. The purpose of these swaps was to switch fixed interest payments that the fund was receiving from the gilts – the fixed interest bonds it had invested in – into floating interest rate payments. And the idea was that those floating interest rate payments were some sort of hedge for inflation. Is that right?

John Ralfe 07:18

That’s just about right, Jonathan? Oh, the underlying bonds that were paying at the time, say 5% – coupon came in on a Thursday, and it was paid out under the swap on the Friday, what we received in return was something that was inflation linked, that wasn’t floating, it was inflation linked, which said, we will pay you RPI plus whatever it was, because of course, the underlying pension liabilities are inflation linked, but then the subtlety is that they are capped at 5%. So if there was no cap, you’d want 100% inflation linked, if you have a 5% cap, you have about 50%, they were called covered swaps. And what that means is that you own the underlying bond, whose coupon you’re playing away under the swap.

Jonathan Ford 08:05

Okay, just before I bring in, Neil, because Neil, I think it’s gonna get a lot of questions here. I just think it’s worth just trying to recap what I think the situation is that you’re describing. You’re describing a situation where a pension fund in a theoretical world it is owning a whole lot of assets, which are supposed to pay out, say, a fixed return of, say, 3%. And it’s swapping that for this floating rate, series of payments. So floating interest rates coming in the opposite direction, you can either actually hold the bonds that pay 3%, or you can say, I’ll hold something else, and bet that that will make at least 3%. And it could go up and I could have more valuable assets. And the risk is that one day you wake up and you find your riskier portfolio is not producing 3%. It’s producing substantially less.

Neil Collins 09:04

It seems to me that what the pension consultants were selling was described as higher returns for lower risk. And that, as we both know, cannot be done. And the thing that I find most extraordinary is how many people drank the Kool-Aid, how many pension managers Trustees decided this was a good thing, and somehow this miracle could be performed. Why do you think it was that it was so widespread?

John Ralfe 09:38

There’s absolutely no question. It was pushed by the investment consultants, the investment consulting business model, they don’t like a simple boots approach where you match your assets and your liabilities and then broadly speaking, you forget about them. So they were pushing something that was complex, because they get paid for complexity. And you could do this because of bad reporting and bad accounting. If the company sponsor could latch on to something which says, do you know what we don’t have to put in deficit contributions amounting to 100 million a year. Because yippee we can continue to hold the private equity, we can continue to hold the the hedge funds, we can do all these esoteric things, which of course, everybody would say – everybody knows, don’t they – the man in the pub knows equities always outperform.

Jonathan Ford 10:25

But John, I want to put another proposition to you, which is that one of the problems with the pure hedged portfolio that you describe is that it was extremely expensive to pull off because it effectively required pension schemes to pour more and more money, which they didn’t have into buying very, very, very low yielding bonds for a very long time. Therefore, you can understand why companies took the view that let’s have a punt on some hedge funds, rather than spend huge amounts of our shareholders money, plugging holes in pension schemes, which then go to lend money to the government. And I think I seem to remember you’ve been you’ve used to berate them for doing this, Neil.

Neil Collins 11:12

I did. Absolutely. And no, and you look at what legal in general have done, for instance, one of the things they have done is rather than putting all the money into gilts at a 2% yield, they have gone into the property development business for long term rental, which is not a bad proxy for the sort of liabilities that they have in the long term. They reckon they can make seven or 8% out of that, which seems to me to be a very sensible thing to do.

Jonathan Ford 11:45

I think the only way to reconcile these different views is, is basically that companies back in the day made pension promises, which were too expensive. And they got found out by what happened in the last 20 years. And basically, it’s been a horrible experience for them. And they have done all sorts of things, including what we’ve been talking about, which is cake driven investment system, I call it CDI-driven investment (Cake Driven Investment) of basically trying to bet on high yielding, racy assets to close the gap without having to pull more and more money into very expensive, long-dated gilt.

John Ralfe 12:23

You’re trying to bet your way out of a deficit. That is like being down at the casinos. But you’re sitting there, it’s two o’clock on the Sunday morning, you’ve lost whatever the amount is. Do you keep on betting? Well, maybe you do. Maybe you don’t. You started with 100 today and 100 today. If in 20 years time, the value of your liabilities has gone up 250. Well, guess what the value of your assets has gone up 250. Why? Let’s suppose interest rates have come down spectacularly which they have over the last 20 years. And it goes up to 150. The value of the matching assets, which are fixed rate bonds, index linked bonds, has also gone  up 250. Because fixed-rate bonds are more valuable, a fixed-rate bond that pays 5%, when the market rate is 3%, will be worth more than par.

Jonathan Ford 13:21

So what I want to do is to move on to where we are now, which is what has been happening in the pensions market. And what happened when the mini budget came out. You’ve actually after all these years of very low interest rates, with the very large liability numbers they threw up, and the deficit which pension funds had, as a consequence, you’ve seen very sharply rising market interest rates in the last few months. And basically, if you look at the five, I think there are 5500 defined benefit schemes left outstanding, closed, or a few still open, I think, mostly close to new members, their liabilities, according to PwC, the accounting firm, have shrunk from 2.4 trillion a year ago to 1.2 trillion. So that this shift has been quite extraordinary as rates have gone up. And overall, according to PwC, again, a deficit on these 5500 schemes, or 600 billion pounds, has turned into a surplus of 155 billion. So in theory, they should be quite happy.

John Ralfe 14:29

(Inaudible) We go back to the mechanics of an interest rate swap, you’re paying over, let’s say 3%. You’re receiving, let’s say RPI plus, back in the day, if you’re a bank, if you’re Barclays Bank if your net worth you doing God knows what value of interest rate swaps in the course, I mean, just goes back and forth. That’s their business. They’re in it to make money. And in order to reduce risk in the overall financial system. There’s a netting. Part of that netting is that for banks – if at the end of the day, Barclays and NatWest, they do all the multi-market netting position, Barclays owes NatWest an amount of money, meaning, if all the swaps were closed out, then because one of the banks went bust, one would owe the other an amount. And I’m not going to Bandy figures around, because I’m not sure what they are. But they’ll be big for what does that bank have to do that bank has to pay over cash collateral, now it takes a setup to do that they’ve got the systems, they’ve got the risk management, they’ve got the reporting in place, what’s happened is, is that that same mechanism, and that same discipline is applied to pension schemes. So when interest rates fall, what that has meant is that the locked in market value of the swap, and there’s some corresponding gain on the other side, the mark to market value of the swap, only the liabilities has gone down by X percent, but the mark to market value of the swap has gone up by X percent, because that’s that’s the match. What that means is that if the company, if the company went bust, then on that day, the bank would be losing money, they’d be an unsecured creditor, potentially, in the company. So individual company pension schemes have been paying collateral. And when you have a situation where the fall of interest rates have that we’ve seen, the amount of collateral that you have to post, normally amount sort of dribble backwards and forwards, and nobody gets terribly excited about it. When you have a very significant movement, the amount of cash collateral that you have to pay over –  and it’s done on a daily basis – and quite what the grace period is, when you get 24 hours or 48 hours before they send in the bailiff, I don’t know it doesn’t matter. But if you need to pay over, I’m saying 100 million pounds. And you’re a scheme that doesn’t have 100 million cash sitting there. What do you do? You have to start selling the most liquid assets? What are the most liquid assets? Hey, presto, they are gilt. What does that do? Well, it pushes the interest rates up on guilts – good news, because it squeezes your liabilities. Bad news, because it means you’ve got to post more collateral. So what we’ve had is something where if pension schemes were just doing covered swaps, yes, it would have been a problem. But it would have been a problem on a much, much, much smaller scale. It’s when you have pension schemes doing this, you know, 100 million covered, and then 200 million naked, in addition to which. Since the financial crisis, the way in which swaps are priced relative to other financial instruments, the price has gone up. So people have said, hang on a minute, we think we can achieve the same goal. Without using an interest rate swap. We can do it through what they call called gilt repos. And there’s a whole thing about leveraged gilt repos. And I have to say, I stick my hand up. I don’t understand how it works.

Neil Collins 18:03
I’m lost long ago, I have to say.

Jonathan Ford 18:06

I just want to once again, try and summarise what you’ve just said, John. Basically, the sting in the tail, as you see it, is that interest rates jumped because of what Kwasi announced in his mini budget. It unbalanced the market in the sense that a lot of pension funds found that their swaps had changed adversely in value. And their counterparties on the other side of the swap said, You’ve got to put more money in more cash collateral to protect us against a possible default by you. And essentially, they had to go and sell some of their assets to meet these calls, which were coming in rapidly. And basically, they had two assets. They had a whole bunch of illiquid equities and private equity, which they couldn’t sell, and gilts, which they could sell. But if they sold, they made the swap problem even worse for themselves. And they were going to end up having to carry on doing the whole thing again, into a sort of doom loop.

Neil Collins 19:14

I don’t pretend to understand this mechanism. But John, do you have a view on why the index-linked stocks didn’t just fall but collapsed? Some of the longer-dated ones actually halved in the day?

John Ralfe 19:30

Yeah, they did. It is worth pointing out and I’ve done this quite recently for various reasons. If you look at what’s happened over the course of the last year, index-linked, prices have been falling, yields have been going up. And that’s because inflation expectations are going up.

Neil Collins 19:44

Which seems contrary to common sense because surely, if you have protection against inflation, they should improve when inflation goes up. I know that this is not the experience, but perhaps you could explain why it is the way it is.

John Ralfe 20:00

I remember 25 years ago, and um, you know, I won’t mention the name of the bank, major UK clearing bank sitting there talking about this and that.  Then he said, see that person over there? He’s the only person in NatWest, that understands the gilt markets. He said, he has an opposite number at Barclays, and at Lloyds and whatever. And he said, they’re not allowed to travel on the same plane together. So I’m ducking, I’m ducking, your question.

Jonathan Ford 20:32

Nobody knows, the answer will be gone. So as a pensioner Neil, are you reassured by all this? Do you think we’re, I’m not? I’m still a bit worried. I think John, John, I sort of feel you’ve left us feeling with a vague sense of unease

Jonn Ralfe 20:50

You should be reassured. You should be reassured, but we should not be complacent. And what was in the whole of the financial system is hidden financial risk, you need to address that you need to tell shareholders you need to report it correctly. And if shareholders are perfectly happy with that, fine, but I suspect they are not credit rating agencies, I suspect Moody’s and Standard and Poor’s and Fitch if they knew about it wouldn’t be terribly comfortable, but they don’t know about it. So be worried, be worried but not too worried, I suppose.

Neil Collins 21:25

That was a long time in finance with Jonathan Ford and Neil Collins. Editing and Production is by Nick Hilton. And our sponsorship partner is briefcase dot news. Join us again next week.

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