REVIEW OF FINANCIAL MARKETS


known with certainty, to the matching of pension obligations whose future values are uncertain in term and amount, and may only be estimated, using actuarial techniques. The Pensions Regulator (TPR) is


prone to describe LDI in these simple matching terms,4


a practice we consider


misleading, but the reality is that most LDI does not have this form, objective, or even motivation.


CHANGING TIMES Changes to accounting standards in the early 2000s drew attention to a company’s pension scheme in annual reports. These standards used market prices (or close proxy arrangements) to value the assets in a scheme’s fund, and present values of the projected pension payments to scheme members as the estimated current value of liabilities. It is worth noting that the standards are mixed attribute in nature. On the asset side, the use of market


prices to value assets has long been criticised as it is obvious that portfolios of the magnitude of pension fund asset holdings could not be realised at such prices, but as that is not typically a required operation, it has become custom and practice within the industry to value assets in this way as if they are readily tradeable and such values could be realised. However, the recent gilt market turmoil has shown this price and market capacity/depth issue to be a concern once again. There have been reports that some illiquid private investment structures traded at prices as low as 40% of their year-end valuations. While on the liability side, the use of


market-based yields to discount liabilities introduces a sensitivity error in the present values derived from those present in market prices. If we have an observation error of 1% in our asset price, the error in valuation is 1%, but if we have a 1% error in the observation of our market-based discount rate, the error in valuation is no longer 1%. With market yields at 10%, a 1% error in


4


See for example, Neil Bull’s testimony to the House of Lords Industry and Regulator’s Committee on 14 November 2022.


5https://www.investopedia.com/terms/i/immunization.asp 6https://www.investopedia.com/terms/m/modifiedduration.asp 7https://www.investopedia.com/terms/c/convexity.asp


Holding to account: analysis and resolution of a crisis Con Keating and Iain Clacher discuss the cause of market turbulence and present a solution in The Review article at cisi.org/giltmarket


observation produces a near doubling of the error in valuation of liabilities for a typical pension scheme. Among the changes introduced by the


changes to accounting standards in the early 2000s was the reporting of scheme deficits in the accounts of the scheme sponsor company. The treatment of surpluses is asymmetric; only the amount of surplus, which may be readily refunded to the sponsor company, is allowed to be reported. The return of any surplus to sponsor is also subject to tax, currently set at a rate of 35%. When combined with the use of a market-based discount rate which introduced and magnified the trend and volatility of market rates into the valuation of scheme liabilities, this provided motivation for schemes to hedge the scheme’s liability valuations. It is important to recognise that this is not the matching of benefits payable with asset cash flows, but rather the matching of changes in asset values with changes in the estimated present value of projected liabilities. While this process may


involve eliminating or mitigating many or all of the factors whose variation influences the projected values of liabilities, such as longevity and inflation, we shall focus solely on the largest, the choice of discount rate employed in the estimation of the present value of pension scheme liabilities. This is also


62


the only factor which is not a determinant of the ultimate benefits payable, and as such it is not a risk of those benefits. This raises a question which has passed without discussion: trustees’ responsibilities lie with the benefits ultimately payable rather than their intermediate valuation, and in this context, actions taken to manipulate these intermediate liability valuations may be beyond their powers, that is ultra vires.


IMMUNISATION The technique used for the matching of hedging interest rate sensitivities is known as ‘immunisation’.5


The first- // TRUSTEES’


RESPONSIBILITIES LIE WITH THE BENEFITS ULTIMATELY PAYABLE RATHER THAN THEIR INTERMEDIATE VALUATION //


order measure used within this technique is the modified duration,6 which, as it is mathematically the tangent of the price/yield curve, is only accurate locally, that is to say, it is only valid for very small changes in the yield or discount rate. Duration is


the local rate of change of the price/ yield curve. The second-order measure, which captures the rate of change of duration, is known as convexity.7 Hedging using these techniques requires periodic adjustment of the amounts of assets held in order to


THE REVIEW MARCH 2023


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