Why do pension funds need to sell gilts in current environment?

NorthernJoe

I’m no economist so excuse the simplistic language in places but I’m trying to understand all of this. Haven't seen a thread on this as yet

I get that pension funds have significant gilt holdings in order that they have some certainty into the future with respect to being able to pay out to pension holders. 

I get that the reckless/unfunded government spending has led to buyers seeking greater yield on gilts.

I understand also that pension funds have insurance against rapid changes in the cost of government borrowing (who wants to be holding an excess of 1% gilts when the market rate is almost 5% for 20 year gilt?).

I don’t understand why this is a crisis though – are pension funds offloading their lower yielding gilts in favour of higher yields? 

Is it the insurance mechanisms which presumably are now “paying out” to cover the rapid rise in yields? 

MX5huggy

My understanding is not that they are selling the gilts but that the value of the gilts is falling. Simply that any pension fund is now worth less and without BoE intervention would actually become insolvent. 

km1500

do they maybe sell a certain number of gilts each month to get cash to pay that month's pension bill ?

or ...

https://www.reuters.com/markets/europe/why-are-britains-pension-schemes-dumping-gilts-2022-09-28/

Prism

They basically borrowed money to buy contracts to boost the yield of the gilts. The falling gilt prices triggered a bunch of repayment requirements (from those contracts), which required them to sell gilts to pay - which lowered the price of gilts, which triggered more contracts etc etc.

DullGreyGuy

Prism said:

They basically borrowed money to buy contracts to boost the yield of the gilts. 

Hu? What money did pension funds borrow?

Linton

MX5huggy said:

My understanding is not that they are selling the gilts but that the value of the gilts is falling. Simply that any pension fund is now worth less and without BoE intervention would actually become insolvent. 

It is worse than that.  I did not nderstand it at all but am trying to fix that.  From my research so far.....

 One would think that DB pension schemes could simply buy gilts with maturity dates that match their liabilities and so could always pay out when a pension is due. It now seems that this only represents part of their assets.  They have also  been clever and bought derivatives ( Liability Driven Investments) whereby someone else is paid to meet the pension schemes' liabilities in exchange for an agreed charge.  These require the buyer to maintain cash collateral to cover the deals against undexpectedly large rate rises/price falls. 

Given the recent behaviour of the bond markets this collateral is insufficient so we have a "Margin Call" whiich requires more collateral.  The pension schemes have to sell assets, but their assets are bonds and bond prices were falling rapidly,.  So the end result could have been the pension schemes going bust.

Hopefully someone who understands the situation better than I can correct errors and misunderstandings.

mongoose2009

you cant taper a ponzi

DullGreyGuy

Are you trying to describe longevity swaps @linton ? 

In a longevity swap the insurer or pension scheme exchanges paying the actual amount due to pensioners with paying the FS/reinsurance company a fixed schedule of payments. Often the providers for these are life insurance companies who want to take on longevity risk (the risk that people live longer than anticipated) as it offsets the mortality risk (the risk people die earlier than anticipated) on their life insurance book. They often arent however to interested in taking on inflation risk as it doesnt help them in any way so often any escalating benefits will be capped if they are uncapped. There may be other "simplifications" the provider wants too.

The insurer / pension scheme therefore are left with 1) a counterparty credit risk... what if the provider goes bust and 2) any delta between what the longevity swap covers and what the anticipated payouts will be. 

In most cases the deal will also be collateralized to reduce the counterparty risk and so on day 1 the insurer/pension scheme would need to be putting up funds for the fee (normally a couple of percent). As time goes on you'll find the actual longevity may be better or worse than predicted and so the collateral may change... if everyone starts dying off early (eg due to covid) then the pensionscheme/insurer will be out of the money and need to post more collateral. If they cure cancer tomorrow suddenly the are in the money and its the reinsurer/FS company that starts need to post the collateral.

dales1

Terry Smith's article in the weekend FT is the clearest explanation that I have seen.

Linton has the basics correct.

(NB the derivatives were often geared to amplify the returns, and so worsening the doom loop (whereby selling the gilts to cover the margin calls on the derivatives, further depressed the price of gilts and caused further calls for margin payments).

Prism

DullGreyGuy said:

Prism said:

They basically borrowed money to buy contracts to boost the yield of the gilts. 

Hu? What money did pension funds borrow?

Borrowed money in a very lose sense - basically made a promise to keep enough cash to pay for the derivatives if it all went pear shaped - which it did. These LDIs seem like a big risk.

mark_cycling00

Imagine you went back in time a month and started telling everyone that LDIs were risky because the government might:

1. commit to borrowing a limitless amount of money to pay people's electricity bills,
2. lower dozens of taxes to create even more inflation
3.forget to publish a plan for how they'd pay for any of it
4. and then on the next day promise to loads more random tax cuts in the future.
5 and on the next day the UK gilt market would collapse like an emerging economy 

Everyone would laugh at you and tell you to wear a tin foil hat.

You'd be right of course but up until 2 weeks ago this scenario was unthinkable for a G7 economy.