Where next for gilt yields – Part 3

In December 2014 I first posted a blog with the title ‘Where next for gilt yields?’ Following a steep downturn in yields over the next two months I revisited this with Part 2 in February 2015. So now, in October 2015 I think it is time for an update.

To start here is the latest version of my yield data graph going back to January 2009:

FRS sept 2015 all

  • Blue: the yield on over 15 year AA rated bonds
  • Red: the yield on over 15 year gilts
  • Yellow: Market Implied Inflation as gilt yield minus index linked gilt yield

The  direction of the red line in Q4 2014 clearly shows why I wrote the first Blog and pointed out three things – which were:

  • Firstly, and probably most importantly, gilt yields show little sign of going up. We haven’t even had much in the way of false dawns. Any spike in yields has quickly leveled off before resuming a downward trend. If trustees and sponsors are waiting for yields to rise, there is no knowing how long they will have to wait.
  • Secondly, the yield gap between gilts and AA bonds has been below 1% for the past 17 months. For those trustees who only use high quality bonds in their matching portfolio this means that a 50/50 gilt/bond portfolio is only yielding 3.09% – this is the lowest yield since I started collating the data in January 2009 (when the composite yield was 5.73%).
  • Thirdly, the yellow line has been above the red line since they crossed 3 years ago – this means that index linked gilts have had a negative yield for the past 3 years. As at 28 November 2014 this stood at an astonishing -0.66%. This means that a buy and hold strategy on index-linked gilts guarantees a significant real loss against RPI.

So, where are we now?

Whilst yields have recovered slightly since their low point in January 2015 they are still significantly below 3%. There is still little sign of any long awaited rise in yields. If trustees and sponsors were waiting for yields to rise a year ago they are still waiting now.

There has been a slight increase in the credit spread. This is now back out to around 120bps from a low of 80bps in February 2015. This has edged the composite yield on a 50/50 gilt/AA bond portfolio back above 3.0%. The difference is that where this used to be ‘the lowest since I started collating data in January 2009’ it now feels more like a blessed relief. The composite yield had dropped to 2.41%in January 2015.

Finally, we seem no nearer seeing gilts generate a positive real return against RPI. The yield on index linked gilts has been in negative territory for all but 2 months out of the last 46. At their current level of  -0.85% there seems little prospect of a return to positive territory in the near future.

In my first Blog I signed off with:

  • “The future is notoriously difficult to predict and always has the capacity to surprise”

I think that remains true, so I will answer my original question by saying:

I don’t know; I won’t be guessing; I will be watching. In doing so I hope that this will help me and my fellow trustees manage each of our unique pension schemes in the most appropriate and pragmatic way we can.

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Where next for gilt yields part 2

When I posted “Where next for gilt yields?” on 4 December 2014 I didn’t expect to be updating it in just over 2 months. But here goes. I have included the text from my previous blog in bold italics.

Where next for gilt yields was down…. by a lot.

This is shown in the updated graph below.FRS Jan 2015

The blue line is the yield on over 15 year AA rated corporate bonds, The red line is the yield on over 15 year gilts. The yellow line is market implied inflation: calculated as gilt yield minus index-linked gilt yield.

In my previous blog I wrote…

There are 3 things that I want to point out from this graph:

Firstly, and probably most importantly, gilt yields show little sign of going up. We haven’t even had much in the way of false dawns. Any spike in yields has quickly leveled off before resuming a downward trend. If trustees and sponsors are waiting for yields to rise, there is no knowing how long they will have to wait.

Update: the yield on over 15 year gilts is now below 2%. As at 30 January 2015 it was 1.97% (Source: IBoxx)

Secondly, the yield gap between gilts and AA bonds has been below 1% for the past 17 months. For those trustees who only use high quality bonds in their matching portfolio this means that a 50/50 gilt/bond portfolio is only yielding 3.09% – this is the lowest yield since I started collating the data in January 2009 (when the composite yield was 5.73%).

Update: the yield gap is still below 1%. On 30 January 2015 it was 0.87%. The composite yield on a 50/50 portfolio was 2.41%

Thirdly, the yellow line has been above the red line since they crossed 3 years ago – this means that index linked gilts have had a negative yield for the past 3 years. As at 28 November 2014 this stood at an astonishing -0.66%. This means that a buy and hold strategy on index-linked gilts guarantees a significant real loss against RPI.

Update: As at 30 January 2015 the yield on index linked gilts was -0.95%

So, where next for gilt yields?

Ask yourself these questions:

1. Can gilt yields get any lower?

2. Can the yield gap get squeezed any further?

3. How long will people accept a negative real return on their investment?

I have revised the chart from December’s blog. It now looks like this.

FRS Jan 2015 blog data

Over the past 2 months we have seen gilt yields fall from 2.44% at the end of November 2014 to 1.97% at the end of January 2015. It is unlikely that anyone could have predicted such a precipitous fall.

As i said in December

“The future is notoriously difficult to predict and always has the capacity to surprise.”

JPR

FRS17/IAS19 disclosures – December year ends and trustee interest

The recent moves in gilt/bond yields look likely to result in an interesting set of FRS17/IAS19 disclosures for many DB sponsors with December year ends. The story is best told by the financial data.

Chart 1: Data for 2014FRS17 16.12.2014

Note: December 2014 figures are as at 16 December 2014.

Chart 2: data for December year ends from 2009 onwards

FRS17 DEc year ends 16.12.2014

Note: December 2014 figures are as at 16 December 2014.

Chart 3: Financial Data from Jan 2009 to Dec 2014

FRS17 from 2009

Note: December 2014 figures are as at 16 December 2014.

As a trustee, I have no role in the FRS17/IAS19 disclosures. These are the responsibility of the directors of the sponsoring employer(s). I do however have a strong interest in them.

In my experience, a tricky set of disclosures is second only to the triennial actuarial valuation in terms of providing a great opportunity for engagement with the employer. I very much suspect that the disclosures for December 2014 will – for many employers – fall squarely into the ‘tricky’ category.

The steep fall of over 100 bps in AA bond yields between December 2013 and December 2014 will have a significant affect on the discount rate used in the disclosures. Whilst there is some comfort from a slightly reduced inflation assumption, an increase in liabilities of between 15 and 25% is a very real possibility.

What such an increase in liabilities does to any deficit will depend significantly on the amount of interest rate hedging in place. If there is little or no hedging it is highly unlikely that any growth in assets will have kept pace with the growth in liabilities. Where there is hedging in place, either through holding a portfolio of long duration bonds or through LDI strategies, some or all of the rise in liabilities should be covered by a corresponding rise in asset values.

Where assets have failed to keep pace with liabilities, this means that  finance directors will be faced with an increase in any deficit and an unfavourable set of disclosures. How this will affect their day-to-day business activities depended largely on the very specific circumstances of the employer. It can affect relationships with suppliers, customers, the bank and shareholders. In practice there is little good news to be had from a set of disclosures that show a deterioration over the past year.

There is one crumb of comfort in the fact that the disclosures do not have any direct influence on the funding plan. On the assumption that there is an affordable funding plan in place – that reflects the strength of the employer covenant – this will not change as a direct result of the disclosures.

One other potential benefit is that the disclosures do provide a useful focus on the investment strategy. This is a good opportunity for trustees to discuss risk and to develop their understanding on the type and quantum of risks to which the employer is willing to be exposed.

So, whilst this year’s disclosure may have the characteristics of an ‘ill wind’, there is some benefit to be had from any heightened employer engagement. This can prove to be very useful when the more substantive issues of the funding plan and the future path of the scheme are considered at the next actuarial review.

Where next for Gilt yields?

Since January 2009 I have kept track of the financial data used to derive assumptions for FRS17/IAS19 disclosures. This is shown in graph form below:

yields graphThe blue line is the yield on over 15 year AA rated corporate bonds, The red line is the yield on over 15 year gilts. The yellow line is market implied inflation: calculated as gilt yield minus index-linked gilt yield.

There are 3 things that I want to point out from this graph:

Firstly, and probably most importantly, gilt yields show little sign of going up. We haven’t even had much in the way of false dawns. Any spike in yields has quickly leveled off before resuming a downward trend. If  trustees and sponsors are waiting for yields to rise, there is no knowing how long they will have to wait.

Secondly, the yield gap between gilts and AA bonds has been below 1% for the past 17 months. For those trustees who only use high quality bonds in their matching portfolio this means that a 50/50 glit/bond portfolio is only yielding 3.09% – this is the lowest yield since I started collating the data in January 2009 (when the composite yield was 5.73%).

Thirdly, the yellow line has been above the red line since they crossed 3 years ago – this means that index linked gilts have had a negative yield for the past 3 years. As at 28 November 2014 this stood at an astonishing -0.66%. This means that a buy and hold strategy on index-linked gilts guarantees a significant real loss against RPI.

So, where next for gilt yields?

Ask yourself these questions:

1. Can gilt yields get any lower?

2. Can the yield gap get squeezed any further?

3. How long will people accept a negative real return on their investment?

Now imagine you had asked yourself the same questions in December 2011.

Would you have said the same back then?

YieldsThe only answer we can realistically give is – we don’t know.

The future is notoriously difficult to predict and always has the capacity to surprise.

JPR

CDC: Why would anyone do that?

It’s official! On my return from the NAPF Conference I told my wife that I was indeed a fully fledged ‘pensions nerd’. My ‘fledging’ was conclusive and its confirmation unequivocal; I had really really enjoyed the annual conference.

Now, you may think that that is not entirely conclusive proof. After all, we did have a captivating and entertaining session from Sir Bob Geldof who, despite everything we were told as a child, made it his personal mission to show us that swearing is in fact ‘big and clever’. We also had another entertaining and enjoyable ‘performance’ from Steve Webb, a great Gala Dinner and a fun session with Dr. Steve Peters to name some selected highlights. Add to that some interesting stream sessions over the three days and an enticing array of entertainment and refreshments on the stands and you have a pretty decent recipe for success. The proof of my nerdiness lies simply in how much I enjoyed just talking pensions to the many people that I met over the three days.

One of the hot topics was Collective DC (‘CDC’), especially after Steve Webb revealed that the interactive voting had seen support for CDC plummet from 80% (before the CDC session) to 57% (at the end). This flushed out a lot of fairly negative views about CDC. These views raised real concerns one of which – primarily about trust based DC – was “why would anyone do that?”

So, why would a trust based scheme want to offer CDC?

Let us set aside the issue of cost. If a trust based DC scheme offers CDC then its governance budget has to increase. For the time being we will assume that the employer is OK with this and will support the trustees’ decision. We will revisit why they might want to do this later.

As a trustee, I can see some real benefits that a CDC option might provide to members. Here’s my thinking on this.

As we know, many trust based DC schemes were spawned from the closure of DB schemes; firstly to new entrants and then subsequently to future accrual. These schemes often have relatively high contribution rates and, as a result, long serving members may reach retirement with decent benefits in the form of both a legacy DB pension and a sizeable DC pot.

The shape of a long-serving member’s benefits might end up looking something like this:

1

For this member the combination of State Pension and DB pension provides a sufficient level of secure income.

This security allows the member to take full advantage of the new ‘freedom and choice’ with their DC pot.

The DB accrual also means that this member retains a semblance of a Normal Retirement Age (‘NRA’). Whilst this is not cast in stone, it does add a focal point for retirement planning.

Over time of course the number of members with appreciable DB accrual will begin to diminish. In the fairly near future, members might reach retirement with benefits that look more like this:

2This member has less in the way of secure income. Their income might not be sufficient to meet their day-to-day living costs.

The benefits of ‘freedom and choice’ start to diminish as the risk of an income shortfall arises.

This member still has an NRA, but the lack of certainty in terms of retirement income can hamper their retirement planing.

This phenomena will  increase over time as fewer members have the benefit of DB accrual. Eventually it will become the norm for most members to reach retirement with no DB accrual. Their benefits may look more like this::

4In this scenario the benefits of ‘freedom and choice’ are seriously eroded by the very real income shortfall.

The member has some difficult decision to make if they are to enjoy a secure retirement.

With no DB benefit there is no such thing as an NRA. The focal point will shift to the State Retirement Age (‘SRA’), but increasingly, SRA may turn into a mere trigger for the payment of the state pension. It may not be sufficient to facilitate genuine retirement.

This is where CDC might fit in. If we can build CDC into the space vacated by DB – albeit with no guarantees and somewhat less certainty – we can rebuild a proposition that is attractive to members and allows them to exercise ‘freedom and choice’ on their conventional DC pot.

5One of the key advantages of CDC would be the idea of the target income.

A target income is a simple idea for members to understand. Not only does it add some substance to retirement planning, it also translates into some some straightforward and effective planning in the form of a required contribution rate.

I see this working particularly well in tandem with conventional DC. Let us assume that a scheme allows members to fund conventional DC, CDC or a mix of both.

The initial contribution rate into the CDC pot would be based on a target income at a target age.

6 Any residual contributions could go into conventional DC. This allows the member to fund for income and to potentially benefit from ‘freedom and choice’.

The beauty of this system would become clear at those times when CDC contributions might need to be increased to achieve the target income.

The contributions into conventional DC could simply be diverted to the CDC section for however long it took for the CDC to get back on track.

From the members’ perspective this is more palatable because their overall contribution rate may not need to go up. In good times the reverse could happen, with excess contributions diverted to conventional DC.

This combination of a target income with some risk sharing might work well from the members’ perspective but, as I stated at the outset, it does require the support of the employer. Which brings us back to a modified question: why would any employer do that?

7If employees do not have sufficient income to retire they might decide – as is their right – to fill any income shortfall with work.

Whilst in principle this may be OK, there is a huge difference between people who work on into old age because they genuinely want to and those who feel they have no alternative.

Whilst there can undoubtedly be some benefit  in retaining experienced staff and many employers will want to accommodate employee requests for flexible working, there does have to be a sense of balance.

A forward thinking employer might recognise that facilitating a good level of retirement income is beneficial for all concerned and CDC might just be a way to make good retirement outcomes possible

JPR

The power of the trusted advocate

Around 20 years ago I was setting up a new scheme for an employer who operated a 3 x 8 hour shift system. The work these folk did was physical and it was dirty. The employer was the UK subsidiary of an overseas business; the UK management had secured funding for a non contributory pension scheme with the option for member contributions. They were quite rightly proud of the deal that they had secured for their employees.

To announce the good news the employer has set up group presentations in the works canteen. The idea was to catch one group before they went on shift at 6am, then the next group as they came off shift at 7am and then the last group at 10pm just before the night shift.

It started badly. There I was at 6 in the morning stood in front of scores of angry (but still relatively clean workers) who didn’t like to be called in early – even if they were being paid for it. I was just getting into the good news of the employer contribution when I noticed that one particularly feisty gentleman, who didn’t much like his employer, was getting increasingly agitated. Eventually he cracked, stood up, angrily tossed his joiners pack back at me and walked out in a loud and somewhat dramatic fashion making it quite clear what he thought of me, my presentation and my pension scheme. After the amusement had died down a few of the wiser heads suggested that I carry on. Their intervention was most welcome and the rest of my  presentation went pretty well.

Somewhat tentatively I moved on to the second presentation. This time the room was full of tired and strangely filthy workers – they were covered in this light film of dust that caught in the back of your throat. I was just about to start when in burst the gentleman from the previous meeting demanding his joiners pack. As luck would have it there it was lying on the table at the front. The pack was snatched from my hand and, to more laughter, my unwitting ally stormed out with a few choice words along the lines of ‘what are you lot looking at?’

The final presentation took place at 10pm just before the night shift. By now I was an object of much amusement as word had spread of the morning’s antics. This was a pretty uneventful session. My friend didn’t put in another appearance.

The strange thing was, despite the trials and tribulations of the presentations, there was a 100% uptake and a large number of voluntary contributions. Now, a non contributory scheme is a smart one to join but, as we all know, that is no guarantee that everyone will do the smart thing. I remain convinced that the reason the scheme was so popular was certainly not because of the brilliance of my presentation, nor was it simply down to the generosity of the employer – although that is clearly a factor. I put it down to the fact that events flushed out the trusted advocates.

The guys at the first meeting who calmed the mayhem down where absolutely key. The very fact that they wanted to be there and wanted to listen, was far more powerful in the eyes of their colleagues than anything I had to say. Now, I don’t know what was said out of the meeting but something must have gone on for our friend to subsequently interrupt a packed meeting and demand his pack. He wasn’t prepared to listen to me but clearly there were people he worked with that he did trust. Just to round it off, he also made a voluntary member contribution. I can assure you –  none of that was my work.

Pensions: Dull, complex and expensive – BUT SEXY!!!

In an earlier Blog (31 October 2013) I once wrote:
“I think it is fair to say that there are perhaps only a few journalists who relish the prospect of reporting on pensions; throw in a bit of tricky looking mathematics and mainstream reporting tends to reinforce the understandable clichés about pensions being dull, complex and expensive. I actually happen to believe that a good pension scheme is, in its way, all three of these things – but that is perhaps a subject for a later blog.”

Below was that ‘later Blog’ written on 4 November 2013 before Steve Webb tried to make things sexy…

Dull: let’s face it everyone knows that pensions are dull. Perhaps that is until the moment you get your pension commencement lump sum or perhaps the day your first pension payment hits your bank account. So, notwithstanding that little period of excitement when your pension – hopefully – gives you the ability to retire in comfort, we probably want pensions to remain dull. The thing is pensions are essentially just too serious to be exciting. I want ‘Match of the Day’, my ski trip, the gig I am planning to go to or latest novel I am reading to be exciting; I want my pension to be safe, secure, steady. I want my pension looked after by serious people who will protect me from any excitement.

Complex: don’t get me wrong I am all for simplicity, especially where simple works well. However, we have to recognise that a level of complexity can be important. I want my pension to be protected by first class governance procedures, I want the custody arrangements buttoned down, I want investment managers vetted and selected via a sound a well-considered process. Above all I want to have confidence that someone is looking after all the complex stuff. I don’t necessarily want to be part of the complexity; I would prefer clear communications and that any choices I have to make be as simple as possible. So, in summary, I want to experience the serenity of the swan gliding across the water; I don’t want to see all the hard work that I know is going on underneath.

Expensive: a good pension costs a lot of money. In order to get a good pension outcome you must have high levels of contribution. There is no magic in the fact that defined benefit pension schemes have provided millions of people with excellent pensions over the years – the simple fact is that these schemes have received large contributions. If defined contribution schemes also received high contributions they too could produce consistently good outcomes. So, by all means make sure that you get value for money from your pension provider and advisers; that is simply good governance and sound business practice. But above all recognise that a decent pension will always be an expensive commodity.

Now, we want them to be sexy.

I will admit that I am as guilty of using this term as many twitter users. In fact I gave a pensions presentation at the Institute for Turnaround’s National Conference a few weeks ago that was predicated on the very idea that pensions are indeed…sexy!

My basic premise was WOW look what they’ve done to pensions! This was before the changes to taxation of benefits on death.

So, the question now is: do i still think that pensions are dull, complex and expensive?

I am willing to change my mind. I enjoy a good reasoned debate and being persuaded to move to an alternative position is an interesting experience. Having said that, on this one I am sticking with my original premise, albeit with a slight addition to the front end in the form of the word ‘Underneath’.

With the benefit of hindsight perhaps I should have written:

” Underneath pensions are dull, complex and expensive”

As i said in my original piece, I am all for simple where simple works. There are a lot of good simple things that are happening in pensions. I would include in this the two big ongoing pension revolutions: automatic enrollment and ‘freedom and choice’.

I love the fact that the only real remaining objection against pension saving – “my money is locked away until I am 55” – is actually one of its real benefits. All the other deep breath moments where you had to explain that  – “yes that is a downside but you need to take that on the chin to get all the good stuff” – have been swept away.

The benefits of introducing ‘freedom and choice’ are palpable and immediate. At my cricket club one of our members turns 65 next January. Near the end of the season we had an animated chat about pensions and all the animation came from him as he explained his rather well thought through retirement plan based on his options from next April. The important thing is that a positive vibe about pensions that comes from those retiring is the best advert pension saving can receive. I do believe that ‘freedom and choice’ has started, in places, to create this vibe.

The key here is that it must be the workers who decide that pensions are sexy. You can’t make people believe that something is sexy – they have to feel it themselves. So – note to pensions industry – please don’t try marketing them in this way.

On the other hand I am very happy for pensions to be marketed in terms of being:

Exciting: yes a financially secure retirement is exciting but somewhere underneath someone must be doing all the dull stuff

Simple: yes please! Make pensions as simple as possible for members. So long as all the complex stuff is taken care of

Value: yes! We all want good value pensions but don’t lose sight of the fact that it takes lots of money to fund a financially secure retirement.

So have I changed my mind?

Well, sort of…

JPR