Liability-Driven Investment? Look, Daft Idea, more like

The Greek Tragedy that is LDI played out this week in front of the Lords’ industry and regulators committee, co-starring the pair of knights at the top of Legal & General, chairman John Kingman and CEO Nigel Wilson. Alas, the victims of the tragedy were not invited to be present, although their time may come. 

LDI, you ask? Oh, come on, do keep up with the acronyms. Liability-Driven Investment is the alchemy that allows pension funds to juice up their returns from “risk-free” investments by buying a derivative. In the most extreme cases, LDIs allowed exposure of £7 to UK government stocks for every pound of derivative.

Pension funds can’t (generally) borrow, but if they want to they can buy these financial thingies which produce a similar effect. They increase the fund’s exposure to the bonds which are routinely purchased with lives to match the dates the pensions must be paid. Please don’t call LDI a bet, that’s far too vulgar. L&G (I am a long-standing shareholder) would not much like you to call them bookies. As the knights explained, they facilitate the LDI purchases, but do not carry much risk. Indeed, the company estimated its losses from last month’s market meltdown at £10m. Some outside estimates put the total of forced sales of government stock in the panic at £500 billion.

Ah yes, the panic. When Barmy Liz and her innumerate Chancellor announced their tax cuts, dealers in the gilts market took one look and ran for the hills. Prices slumped (and those of index-linked stocks collapsed) leading to the providers of the clever derivatives demanding more collateral to counter the lower value of their security.

Only the emergency offer of £65bn of support from the Bank of England stopped the rot, in what was Andrew Bailey’s finest hour (to date). The day was saved, although some companies are likely to find themselves being asked to contribute more into their employees’ pension funds to cover the cost of the little misadventure. Some boards might decide to move the management contract to a manager less keen to take this sort of risk.

So far, so (reasonably) well understood. But the central mystery is why the pension funds loaded up with long-dated gilts in the first place. These bonds might have matched the dates for the pension payments, but until the start of this year, the returns they were offering were pitiful, typically around 1 per cent, far less than is needed to keep pace with the growing liability of a defined benefit scheme. The LDIs would juice that up, of course, but buying a 30-year stock on a yield of 1 per cent could be a definition of madness for any student of UK history.

In theory the yield could go down further (i.e. the price of the stock would rise) but it would have required some heroic assumptions about a sea-change in Britain’s incontinent economic policy for that to come about. Of course pension funds are supposed to be long-term investors, but the cost to a fund of not buying at 1 per cent, and keeping the money in near-cash, was modest even with Bank Rate at 0.1 per cent. The financial repression that gave us those conditions, with the Bank of England supporting prices through its Quantitative Easing programme, could not last, and any funds which stayed liquid can now buy 20-year gilts to match their liabilities on a yield of 3.3 per cent. Not exactly a bargain, but a lot better than 1 per cent.

The lesson from this tale is the usual one: in investing, anything that promises a better return than the market price also raises the risk for the investor. They are two sides of the same coin. The shocking thing is that all those experienced professionals had failed to learn it.

Office for Economic Cant and Decline

Once again, it is time for the pompously-named Organisation for Economic Co-operation and Development to savage the UK. From its agreeable, tax-free offices in Paris, the OECD tells us that it works for better policies to build better lives, and its forecasts are taken as something close to holy writ in the British media. This time, we’re bottom of the class, with miserable prospects for growth, with risks to the economy “tilted towards the downside”. The energy support scheme raised the prospect of inflation staying higher for longer, it added.

It’s all pretty grim, but is it right? When the OECD was invented, half a century ago, economic forecasting was a novelty. Now every self-respecting bank has its own department, often analysing and forecasting in great detail. Independents like Capital Economics are at least as good (or bad) at projecting the future as the OECD. It is redundant, and well past time this taxpayer-funded organisation was sent off into the sunset.

For a less gloomy take on prospects, listen to this week’s podcast of A Long Time In Finance, with me and Jonathan Ford.

Write to us with your comments to be considered for publication at letters@reaction.life