Why are UK pension funds in huge trouble for no good reason?

Take a 1970 textbook and you will read something like: Pension Funds (PFs) need to make payments that are quasi certain and therefore should invest in a portfolio of bonds whose payments matches these obligations. Simple. Nothing can go wrong.

But, this is a bit boring and if central banks set bond yields to below inflation levels, there is no way you make it.

So, PFs invest in a portfolio of bonds, equity, alternatives and 'statistically' it should be ok. That is, they have a chance not to have enough money for these payments depending on how markets go, but it should not land too far, so, all good (ish).

But what is annoying in this setup is that you want to track where PFs are in their asset/liability to know where they will land. Thus regulators now to live-track where PFs are in terms of assets and liability.

[Aside: We may need to rethink this, but commonly accepted way to measure pension liabilities, is to discount future payments with the interest rates on bonds.]

Problem: if interest rates go down, liabilities increase and PFs look like they are underfunded, regulator is alarmed, and a fairy trustee dies.

This is what has been happening with USS (my pension fund): their assets have grown a lot over the last decade but this discounting rule means it looked bad and universities were asked to add contributions (profs protested hard etc.)

And here comes the usual twist (Finance is just like romantic comedies really): A finance pro hears there is a problem, and thus offers a solution (in order to make lots of money selling it). Usually it is sweet when people think of solutions but in Finance when someone says they have 'solutions' it is code for 'Run, Forrest, Run'.

Here, solution was: How about you buy a product that pays you if interest rates go down (since you hate that situation) but ask you money if they go up.
The finance pro (advisor/intermediary) makes money of course (fees) while leaving you with the consequences.

And consequences are deer: If you enter into the above contract, and interest rates go up, the counterpart (who sold you this product) asks you for immediate cash because on paper you are losing money (margin call) and if you do not deliver, you die. This is how every single financial institution goes bust actually!!!

PFs should never be in a situation of defaulting on margin calls and in fact in many countries PFs are restricted in their use of derivatives and leverage for this very reason!!!

But where are all these intermediaries who sold that stuff? And the trustees that signed up? Until we force trustees to get proper education, and not 'free lectures' from advisors as it is currently the case (!), change incentives in the finance industry (stop paying people a fraction of revenues they generate), distribute massive fines to the culprits, this will keep on happening.

Phafa Le Hardi Written by: