PensionsMedium

3 min read · 515 words

What the seat actually does

A pension scheme owes payments to people who will draw them for decades. This seat invests towards those payments and reports whether the scheme is on track.

Two arrangements, and they are not variations of one thing. Under a defined benefit promise the scheme owes a specified income and carries all the risk of getting there; under defined contribution the member carries it, and the scheme's job becomes providing sensible defaults to people who will mostly never change them. Confusing the two is the most common mistake in reading anything about pensions.

• The funding level — assets against the present value of what is owed, which moves with rates as much as with markets.
• Liability hedging — matching rate and inflation sensitivity, usually with swaps and index-linked bonds.
• Growth assets, held to close a gap the contributions alone will not.
• Default design, on the defined contribution side, where the default fund is what almost everybody ends up in.

A day, and where it goes

• The funding level, which moved overnight because the discount rate did.
• Collateral for the hedges, and how much is available without selling growth assets.
• Cash flow — contributions in, pensions out, and which direction the scheme is net.
• Member outcomes, on the defined contribution side: what the default is actually delivering.

What it is measured on

• Funding level and its volatility, not the return on the assets alone.
• Hedge ratio — how much of the rate and inflation sensitivity is actually matched.
• Collateral resilience — how large a move in rates the scheme can meet without forced selling.
• For defined contribution: what a member is projected to have, and how sensitive that is to costs.

What it touches on this site

• The instruments — inflation-linked bonds, swaps, annuities and repo, which is how the leverage is obtained.
• What the fees do — costs and fees and what they actually cost, which over forty years is the largest single lever.
• Building the allocation — the playbook.
• When it goes wrong — 2022, where the hedge was correct and the collateral was not there.

How it goes wrong

• A hedge financed with leverage and no collateral plan. The position that protects the funding level is the one that calls for cash when rates move fast.
• Discount rate optimism. Assuming a higher return makes the deficit smaller on paper and changes nothing about what is owed.
• Selling growth assets to meet a call, which locks in the loss and reduces the very thing that was closing the gap.
• Defined contribution defaults nobody revisits, which is where most members' outcomes are actually decided.

Concepts to master

• A liability has a duration, and it is usually longer than anything easily bought.
• The discount rate moves the deficit more than a year of market returns does — see IRR and NPV.
• Costs compound against the member exactly as returns compound for them.
• Leverage needs a liquidity plan, always — see margin and collateral.