How Britain was caught in a jasmine-scented trap


        By : Bill Jamieson January 22, 2006

      BRITAIN’S ever-deepening pensions black hole is set to erupt in a big political row for the Treasury as fund managers, regulators – and tens of millions of savers – watch helpless and bewildered at the unfolding crisis in the government gilt-edged market.

      The storm threatens to dwarf the pensions mis-selling and with profits shortfall scandals of recent years – though this time around with the government and the regulatory industry in the firing line.

      For anyone saving through a company pension scheme or long-term with-profits insurance company fund in Britain, the extraordinary events of the past week have made for especially grim reading.

      Far from the pensions “black hole” receding with the recovery in stock markets, it grows alarmingly deeper as yields on long-dated gilt-edged or government stock have fallen.

      The fall in bond yields has been worldwide. But in the UK the falls have been much greater. Last week, the real yield on the 50-year index-linked gilt slumped to 0.57% – below that of an index-linked bond in deflationary Japan. In this surreal terrain, pension-fund managers have been
caught in a vicious circle: they are obliged by regulation to reduce risk exposure by more closely aligning assets against liabilities. This means more investment in long-dated gilt edged stock for the greater certainty of returns, and less in volatile equities.

      But the greater the investment in long gilts, the further that yields have fallen ­– and the greater that pension deficits have grown. Put another way, the more the fund managers seek to fill the hole, the bigger it gets. The result is akin to a demented Doomsday machine in a sci-fi horror movie.

Pension deficits of FTSE 350 companies have risen by £20bn (E29.2bn, $35.4bn) this month alone, while the pension fund liabilities of companies in the FTSE100 are reckoned to have leapt by £35bn in the past six months. This is despite a recovery in pension savings and a strong rally in the
stock market that has swept up the FTSE100 Index by more than 60% since March 2003.

      Savers are now aghast that while stock markets have risen sharply, the ability of their pension funds to deliver on their promises has declined. Fund manager F&C says the crisis could raise the average pension fund deficit by more than half.

      According to Jeremy Toner, fixed-income portfolio manager at Investec, the herding of pension funds into the long end of the index-linked market “has created a bubble and arguably a disorderly market which is forcing pension funds into uneconomic investment decisions”. The bubble, he believes, “will eventually burst when pension fund demand for bonds falls as it is generally expected to do over the next decade”.

      The potential political fallout is colossal. Not only are spiralling pensions deficits creating huge uncertainty in corporate Britain, with company mergers made much more complicated and efficiency gains more than wiped out by widening pension liabilities, but the incentive to save is also being hit.

      The list of UK companies closing or modifying their pension funds grows with every week. Retail group John Lewis and brewer Scottish & Newcastle are the latest to announce cutbacks to previously agreed pension benefits. And with no light at the end of the tunnel, pressure on the
government’s Debt Management Office (DMO) is set to grow. Says Paul Rayner, portfolio manager at Royal London Asset Management: “Demand from UK pension funds will increase. Deficits will grow as liabilities are discounted at historically low interest rates. The DMO has a responsibility of maintaining an orderly market, but the situation has been exacerbated by the fact that
there will be no long-dated conventional supply until the end of February.”

      How did Britain get into this tangle? Why have long-dated gilt yields fallen further than in other countries? And what should be done? 

      Low bond yields have become a familiar part of the global financial landscape. Falling prices for manufactured goods from Asia, particularly China have helped to pull down inflation and interest rates round the world. But what has puzzled many, all the way up to former US Federal Reserve governor Alan Greenspan, is the “conundrum” of low yields on long-dated bonds.

      A benign interpretation is that financial markets now have unbounded faith in central bankers to keep inflation down in the longer term. Altogether less benign is the classical interpretation: that low long-term yields signal very little confidence at all in the future and the onset of
recession – or depression.

      Low US yields may be explained by the popularity of US bonds with Asian investors. But what explains the position in the UK where long real yields have fallen below those in France and the US? One potent factor playing on the UK pensions and long-term savings market has been the growing influence of the regulators. Institutions are now obliged to mitigate performance volatility by investing in fixed-interest securities.

      This phenomenon was best exemplified by insurance giant Standard Life. Its huge with-profits fund had been caught overexposed to equities at the top of the market in 2000. Policyholder bonuses were cut as the market fell. Standard Life was then “encouraged” by the Financial Services Authority to switch out of equities into fixed-interest stocks. This it did in dramatic
fashion. In January 2004, in a secret operation code-named Project Jasmine, it switched £7.5bn out of equities and into bonds. It was the biggest single such asset shift ever undertaken by a UK institution. Other companies followed, though not in a move of such magnitude.

      Project Jasmine did not leave the with-profits fund smelling any sweeter for the policyholders. In fact, it had the effect of compounding the error of being over-exposed at the top by selling out of shares when the market was low. The FTSE100 has since recovered strongly. But Standard Life
policyholders have continued to suffer bonus cuts.

      Similar pressures have been evident on pension funds, and with equally perverse results. Says Toner: “The need to meet regulatory requirements and avoid risk-based levies drives companies to reduce the volatility of their pension-fund deficits by buying long-dated index-linked bonds regardless of their investment merits; this real yield is then itself used as the rate to discount future pension-fund liabilities, which therefore rise, thereby forcing more investment into long-dated index linked bonds.”

      This is an extraordinary state of affairs for which the regulatory agencies and the government are largely responsible. The DMO can issue more long-dated debt and/or shift the maturity of the government’s own debt pile. But fund managers must be allowed greater discretion in asset allocation. To have today’s perverse situation where pension funds are required to invest in assets against their own interest and common sense is surely no way to manage Britain’s pensions industry.

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