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Weekly Comment, Week 36, 2016Following on from James Downie’s most recent weekly view “UK Pensions Time Bomb”, I would like to add a further view. James’s report highlighted the perilous state of UK Defined Benefit (DB) pension schemes, their funding deficits, regulatory complications and the impact of central bank zero interest rate policies. He is right and it is undoubtedly a time bomb, but added to this, the actuarial and marketing departments of asset managers have come up with the ideal way for these investors to ensure they never close this funding gap: it’s called “asset liability matching”.

Kerr Neilson, founder of Platinum Asset Management in Sydney and highly regarded by us at MitonOptimal, highlighted in his latest quarterly report “the seemingly absurd phenomenon of life insurers and pension funds shifting money away from equities to buy more long-dated low-yielding government bonds, as a result of the prevailing low interest rates”.

Unlike defined contribution savings platforms, life insurers and defined benefit schemes have long-term liabilities, which they must match with long-term assets. For the last 30 years, the ideal way to achieve this match would have been to own long-dated government bonds, which participated in the biggest bull market of recent time as U.S. yields fell from 15% to effectively nil. Fact! How about another fact: this approach is not mathematically possible for the next 30 years.

Week 36, 2016 - Fig 1

Fig 1:

It is commonly agreed that liabilities are inversely correlated with government bonds i.e. as long term interest rates have fallen, the liabilities of insurers and pension funds has actually risen incrementally. The above chart (Fig 1), courtesy of the Platinum Asset Management article, clearly highlights this. Additionally, most pension fund assets have underperformed, as they have been significantly overweight global equities since the bubble of 1999/2000, rather than government bonds. Now, however, these so-called clever advisers recommend buying the most overpriced asset on the planet because, as liabilities fall when interest rates rise, so will the assets! Surely the only real chance of solving this massive time bomb is ensure assets rise when liabilities fall over the next 30 years?


Week 36, 2016 - Fig 2

Fig 2:

The second chart (Fig 2), from the Wall Street Journal, highlights the challenge facing private investors seeking a 7.5% return within the prevailing lower interest rate environment. Interestingly in 1995, when interest rates were significantly higher, a private investor could invest 100% of their money in bonds for that 7.5% return. Thus, the rule of thumb (in financial planning) that the proportion of one’s assets invested in bonds should be equal to one’s age – i.e. 70 yrs equals 70% in bonds – was entirely sensible. By 2005, however, this had changed to 50 bonds/ 50 elsewhere and in 2015 the only possible way to earn 7.5% (based on forward looking return expectations) is with only 12% bonds and the rest in TINA (There Is No Alternative) assets. As shown, that is also accompanied by much higher expected volatility (standard deviation).

So, individual investors are being recommended (and forced by central banks) to have the lowest level of bonds ever to achieve target returns whilst the Defined Benefit Investors are being recommended to buy 100% bonds to match their liabilities. This is madness! And this may be the biggest grand theft of the next 30 years: what were once considered gold-plated “DB company pensions” will be rubble.

Asset Liability Matching Madness


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