REVIEW OF FINANCIAL MARKETS


maintain the accuracy of the hedge. It is, however, significantly less costly to implement than the strategy of dedication, which does match, and continues to match through time, the duration and convexity of assets and liabilities. Duration is a measure of the term of a


sequence of cash flows; in the case where the discount rate is set to zero, it is simply the average life of the sequence. There are also estimation problems for the duration of non-gilt securities. Durations may even be derived for equities (students are often surprised that this is usually relatively short – between eight and 12 years). The market yields of these non-gilt securities reflect not just the time value of money, but also the specific default and other idiosyncratic risks, such as the security’s liquidity. Duration, measured without correction for these factors, will understate the riskiness of the security as interest rate sensitivity. Hedging of the valuation


duration of the UK DB sector varied by over 12%, more than two years in term. During that day, the present value of UK DB liabilities varied by £181bn – to offer this a sense of scale, the total UK national tax receipts for 2021–22 were £718bn; the variation was equivalent to 25% of total annual tax receipts.


// SCHEMES CURRENTLY OWN FEWER ASSETS BY VALUE FROM WHICH THEY WILL HAVE TO PAY PENSIONS WHICH ARE BASICALLY UNCHANGED //


uncertainty could in theory take place in either scheme or the sponsor, but we have not encountered any case where the hedging has been undertaken within the sponsor. There is, of course, a reason for this, which is that TPR can and will insist on additional contributions being made by the sponsor when the scheme is reporting valuation deficits. There are also further differences between the statutory valuation requirements of schemes and their equivalent sponsor accounting requirements, most notably that scheme accounts should be prudently based, using assumptions and discount rates which are prudently based, while sponsor accounts should be based on best estimates of those values. The Pensions Regulator appears


married to interest rate sensitivities and is promoting the use of duration as a measure of scheme maturity, with 12 years being the trigger threshold for action in the proposed new DB Funding Regulations and associated Code, when in reality the average life of the scheme would be more intuitive, more predictable, and stable. To highlight this, there was a single day during the gilt market turmoil when the modified


CISI.ORG/REVIEW


FUNDING RATIO The funding ratio is the most commonly used and cited measure of the financial health or sufficiency of the scheme. It is simply the ratio of the value of the scheme’s assets to the present value of scheme liabilities. As we have not seen the theoretical statistical properties of this ratio described elsewhere, we provide these in Box 1. The


funding ratio is


often presented as if it is a settled and certain fact, when it should in fact be treated as the estimate it is, and good practice would require its confidence intervals to be shown alongside its estimated value. Under normal market volatility


conditions, for a fully funded scheme, the one standard deviation confidence interval ranges from 96.2% to 104.1%. Under the market conditions seen recently, that confidence interval has expanded, ranging from 89.1% to 112.6%. These values have been estimated by simulation from empirical data on


intraday prices and yields. There are very few, if any, schemes employing LDI with improvements large enough to qualify as statistically significant; there are many not employing LDI where the improvements are statistically significant. Many of the advocates for the


widespread continuance of LDI, including TPR, have been quick to point to the sector-wide improvement in the estimated funding ratio of DB schemes overall. The majority of this improvement will have been delivered by schemes not employing LDI. None of it should have been delivered by schemes employing LDI fully, as that was by design intended to eliminate both positive and negative variations in valuations. The most elementary analysis of the


crisis tells us that schemes now have far fewer assets than at the beginning of the year. Simply put, schemes currently own fewer assets by value from which they will have to pay pensions which are basically unchanged. Common sense tells us that a greater


reliance on uncertain future returns is riskier, but the modified duration, which will have fallen with rising interest rates, suggests that the assets and liabilities have a shorter modified duration and are less volatile or risky. It is also far from certain that the expected returns from assets held will warrant the use of the higher gilt yields as the scheme discount rate, given the various sales and other actions taken to meet collateral calls. In distress, these sales included the high-growth, high-return assets of schemes, and this was done without any true regard for their return prospects.


BOX 1: STATISTICAL PROPERTIES OF THE FUNDING RATIO


To model the funding ratio (r) analytically, we begin by considering both assets (A) and liabilities (L) to be lognormally distributed.


The variance is then just the sum of the two original variances, so if the ratio is r and r = A/L, Var(log(r)) = Var(log(A)) + Var(log(L))


The means should just be the difference of logs: E(log(r)) = E(log(A)) - E(log(L))


63


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32  |  Page 33  |  Page 34  |  Page 35  |  Page 36  |  Page 37  |  Page 38  |  Page 39  |  Page 40  |  Page 41  |  Page 42  |  Page 43  |  Page 44  |  Page 45  |  Page 46  |  Page 47  |  Page 48  |  Page 49  |  Page 50  |  Page 51  |  Page 52  |  Page 53  |  Page 54  |  Page 55  |  Page 56  |  Page 57  |  Page 58  |  Page 59  |  Page 60  |  Page 61  |  Page 62  |  Page 63  |  Page 64  |  Page 65  |  Page 66  |  Page 67  |  Page 68  |  Page 69  |  Page 70  |  Page 71  |  Page 72