“The latest monthly estimates from the Pension Protection Fund make grim reading for corporate finance directors. According to the PPF, the aggregate balance of the 6,653 index of pension fund balances, measured under section 179 valuations, showed a sharp deterioration in the balance of pension fund deficits from a surplus of £6.6bn in July, to a deficit of £53.5bn in August, although this is a marked improvement on the £124.8bn aggregate deficit on August 31st 2009. As the PPF’s chart 1 shows, the aggregate funding level sank from 100.7% to 94.6%. The PPF also noted that there were 4,701 schemes in deficit and 1,952 schemes in surplus.
“The section 179 assumptions represent the premium that would have to be paid to an insurance company to assume the payments of Pension Protection Fund levels of compensation. The monthly estimates are produced by the PPF utilising a complex pricing model and incorporating complete actuarial data (although in does not include derivative hedges). For August the PPF concluded that fund assets rose by 1.4%, largely due to rising UK and overseas equities, but that liabilities rose by 8% due to the significant fall in gilt yields.
“The second chart provides a simple reduced replication of the PPF model. This utilises two factors, 15yr5yr forward gilt yield and the FTSE100 index. In formulating this model, we used a number of instruments and tenors, but found that the 15yr gilt yield 5yr forward together with the FTSE100, provided the best explanatory variables with an R-squared of over 0.7.
“However, what is more important is why the PPF’s model can be dimensionally reduced to a two factor model. In our view this suggests that the average defined benefit corporate pension fund continues to use dirty hedges to match its liabilities. The firming up of the defined benefit pension promise by the previous government has transformed corporate pension funds into fixed income instruments, whose closest hedge is risk free government bonds. However, pension sponsors have continued to maintain exposure to equities and have obtained their expose to fixed income through a combination of medium dated corporate bonds and we assume ultra long dated conventional gilts in a misguided attempt to match their duration.
“The simplified model highlights the exposures produced by these dirty hedges, which show the industry is exposed to 15yr5yr to the tune of £690mn per basis point and to the FTSE100 to the tune of £4,000mn per 1% move in equities. Dirty hedges and Dirty Harry, how lucky do corporate pension fund sponsors and trustees feel about this risky asset-liability mis-match. The answer is likely to become clearer over the next few weeks. As our chart shows, our model suggests that the combined deficit has narrowed by £35bn since the start of September. This reduction is the product of a 6.25% appreciation of the FTSE100 and 21bps rise in the 15yr5yr forward yield since the start of the month. However, the volatility of this position is evidenced by the movement over the past 24 hours, where in response to the Fed’s FOMC statement, (which virtually guaranteed more quantitative easing in the next few months and in turn will be inevitably followed by QE2 from the Bank of England), 15yr5yr forward yields have fallen by 17bps, implying a £11.7bn deterioration in the deficit.
“We have named our model the Bad Santa model after its creator and its possible that this exposure will ruin Christmas for many corporate Finance Directors. For a material number of pension funds, the past month has enabled them to get back into surplus, but the heighted asset volatility is likely to persuade them that this substantial asset-liability mis-match is both unacceptable and unnecessary. There is a clear risk that they will seek to reduce this risk by more accurately hedging their exposure to gilts. This seasonal liability investment driven demand is likely to compete with anticipatory buying ahead of the Bank of England’s own gilt purchase program. Quantitative easing is explicitly designed to lower the term structure of interest rates in order to Keynes’ animal spirits. As our final chart shows, the current level of 15yr5yr yield of 4.92% is still too high from both an historical and current economic conditions perspective. This rate could easily fall by 100bps over the next six months under a concerted period of quantitative easing from the Bank of England. Pension funds would be well advised to try and beat the Christmas rush and hedge their exposure.”
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These are the views of the author and do not necessarily reflect those of Ignis Asset Management.