#1 Pension funds’ defined benefit liabilities SHRINK when (long term) interest rates are HIGH.
Six years ago when long term interest rates were historically low but somewhat higher than they are now, you and your fellow trustees convinced yourselves that rates were bound to rise to “more normal levels” so there was no need to insure (hedge) against the risk of interest rates falling. It was a supremely large one-way market bet, but you went ahead and made it anyway. Unfortunately, rates didn’t rise. They FELL.
Four years ago when interest rates were still higher than they are now, the board of pension plan trustees again convinced itself that interest rates were “very likely going to rise” so, on balance, there was no need to hedge against the risk of them falling. They DID fall some more and it became even more imperative to hedge / insure.
Two years ago when interest rates were above where they are now, you were still certain that interest rates were destined to rise to their “mean reverting norm” so there was no pressing need to hedge against the risk they might fall. They did not rise, they .... fell.
You still haven’t hedged against falling interest rates. Interest rates are still falling.
“It’s not supposed to be happening” but it is.
#2 Index linked pension plan liabilities SHRINK when inflation expectations are LOW.
Six years ago when inflation expectations were lower than they are now, you convinced yourselves that they were sure to go lower – after all, how can inflation rise with interest rates falling? “It’s basic economics” you said. "There is no need to hedge against the risk of inflation rising." It was an enormous gamble (given the size of the deficit and the stress on the corporate sponsor if they did rise) but you took it anyway. They rose.
Four years ago when inflation levels were still lower than they are now, your advisors said that they “were sure to go lower” so there was no need to hedge against the risk of them rising. They rose.
Two years ago when inflation levels remained lower than where they are now, you were absolutely convinced that this time they "just HAD to fall” ("otherwise, think how many letters the Governor would have to write to the Chancellor") so there was no need to hedge against the risk of them rising. They rose.
You still haven’t hedged against rising inflation expectations. Inflation expectations are still rising.
“This isn’t supposed to be happening either” but it is.
The combination of Reason #1 and Reason #2 means the Real Yield is turning NEGATIVE across the curve. Very bad. Very dangerous.
#3 Many years ago, a famous guru propounded the theory that if you invested in equities over the long term, you COULD NOT LOSE because, he said, you would be paid the ERP, that is, the Equity Risk Premium.
He said: Sure, equities go down sometimes, they even plummet, but they ALWAYS come back and, when they do, you make way more than you ever lost when they went down / plummeted. Because of the ERP.
It would have been a fantastic theory if it had worked in practice. Unfortunately, despite the fact that the ERP has been undeniably AWOL for some time now, you clung doggedly to the guru’s theory and piled into even more of this asset class even as it failed to deliver on the ERP promise. In fact, you're thinking of “doing some more” right about now.
#4 When the markets go into spasm, or discombobulate themselves in a collective paroxysm of global volatility, there is no clear game plan to allow you to move rapidly and decisively in order to take advantage of significant but temporary opportunities. For example, when inflation expectations fell by a massive 15bp(!) last week, you were not in a position to hedge/insure even a small part of your pension liabilities. Given that two days later the chance had gone, (they do), you missed a golden opportunity. You will miss it again next time.
#5 You have not realised that you have much less time than you think. You always say: “It’s a long term thing, the pension fund” meaning “We’ve got 40 years to let things sort themselves out.”
In fact you have less than 10 years and (given the market’s current perilous state) you probably don’t even have that.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]