How could such leverage on pensions in the UK remain invisible?

We might never have known the extent of the hidden leverage in UK company pensions had it not been for the crisis that followed last month’s ‘mini’ budget proposed by UK Chancellor of the Exchequer Kwasi Kwarteng. Leverage should not be a problem if properly managed. But it needs the disinfectant of sunlight.

Contractual pension promises are actually a form of debt: the employer owes employees a future sum. The problem is that this obligation is a moving target. It rises with long-term inflation expectations, since pensioner incomes are generally linked in some way to consumer prices. It also jumps with the progress of longevity because pensions must then be paid longer. And there’s some subjectivity in how you put a present value on a payment to be made in, say, 2045.

For this reason, there has been a welcome increase in company disclosures about how pension promises are calculated in recent years – largely due to regulation. Company annual reports contain details of the estimated cost of paying pensions as well as what it might look like if actuaries did the calculation differently. IAS 19, the accounting standard for employee benefits, requires companies to define the risks of a pension plan that could affect their cash flows. But one-size-fits-all advice is necessarily general rather than too specific.

Unfortunately, assets set aside to meet liabilities haven’t received as much attention until recently.

You can see why. Calculating the value of assets seems quite simple. It is usually a mix of government and corporate bonds, stocks, real estate investments and private equity. Most of them will have a daily market price or at least a recent bespoke valuation. Companies usually provide granular details about this portfolio, but what investors see is essentially a snapshot valuation at year-end.

The current level of disclosure is clearly inadequate. What we have learned this year is that assets are also opaque, thanks to the use of derivatives. Some pension plans have entered into contracts to hedge against increases in the book value of liabilities caused by declining bond yields in recent years, in an approach known as equity-driven investing. passive.

But when bond yields went the other way, rising sharply as they did last month, pension plans using this strategy had to put up collateral to back those derivative positions. Plans without decent cash reserves had to hastily sell portfolio holdings, putting downward pressure on asset prices – especially UK government bonds. The other option would have been to make an urgent call to the company supporting the program to ask for an injection of funds. As it happens, the Bank of England ended the rot by backing gilts, buying time for pension schemes to meet no-sell collateral claims.

It is likely that this problem has mainly affected petty funds that are in deficit (pension assets are worth less than the corresponding liabilities). But it’s hard to know where this is actually happening because it’s just not clear.

The concern of financial regulators is the orderly functioning of markets. But who cares about the shareholders of a company whose pension plan might run the risk of an unexpected call for funds that it cannot meet?

If the employer backing the plan responds to a panic call for money, they may not see the funds returned. The potential for such requests should weigh on his credit rating. And if the pension plan gets rid of assets on the cheap, it will likely mean that the company will have to make additional top-up payments into the plan over the long term. Either way, shareholders foot the bill.

The current voluminous annual corporate pension disclosures don’t really take these risks into account, although some industry experts have sounded warnings. The main reform would be to require much greater transparency of derivative positions, supporting a sensitivity analysis of how the portfolio would behave if markets moved sharply, similar to what we have for pension liabilities.

A parallel benefit of such transparency is that pension funds would find out if they could rush for the same exit in a crisis. Investors should push for disclosure. If companies are unwilling to provide it, their pension plans should probably change their investment strategy.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering the deals. Previously, he worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.

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