Lots of talk this morning about the smoothing of discount rates. You already know all of the following i.e.
- The FT article and the market moves as outlined below
- 7bps sell off in long-end gilts (i.e. higher gilt yields)
- 4bps sell off in swaps (i.e. higher swap yields but clearly swaps not being hurt as much gilts)
- 3bps tightening of swap spreads (so you get more juice versus LIBOR when you asset swap your gilt)
- 2bps sell-off in breakevens (i.e. RPI-only hedging is cheaper by at least 2bps as a result of linker real yields selling off more than nominal gilt yields)
- http://cdn.hm-treasury.gov.uk/autumn_statement_2012_complete.pdf (page 44 - 1.137)
But……for me this morning’s news brings back memories of 2008, when I was getting myself acquainted with the US LDI market, and came across the letter below to congress by global actuarial firms calling for a smoothing of discount rates (page 2 last bullet point). As an astute observer remarked, this was written almost 4 years to the day that we have this announcement about the consultation on “smoothing” in the UK.
Now, of course, we must recognise that those were very different times and in a different geography, nevertheless in a market that is thirsting for information which may give clues to how the various stakeholders in UK pensions may respond, I thought this was interesting enough to be shared.
Of course, the story doesn’t end there because this year the US enacted MAP21 which effectively converted the “temporary relief” in discount rates, proposed in 2008, into a more permanent one. I am not going to summarise MAP21 because I think the notes below from Aon Hewitt Ennis Knupp (AHEK), as they are known in the US, as well as Towers Watson do a far better job of this than I could but the implications are similar to those we witnessed in the Dutch market when the UFR was introduced, and in particular the steepening of the long-end Euro rates curve that accompanied the introduction of the UFR.
The key point to note from MAP 21 (when comparing to today’s announcement in the UK) is that MAP21 actually allows the discount rate to be a function of 25-year average rates. That’s not a typo – that’s twenty five years! There are lots of subtleties here which make a direct comparison to the UK more complex than is apparent at first sight, e.g. US discount rates are a function of corporate bond yields rather than Treasury yields, so the devil does lie in the detail but even this doesn’t change the fact that the impact of MAP 21 on discount rates is significant.
If we get anywhere close to MAP 21, we are all going to have start thinking about whether we choose to hedge the true economic liability or the “regulatory” liability. As the AHEK note summarises on page 9, the impact and course of action that any specific plan follows is going to depend on their own specific position with regard to (at least) 2 factors - “risk budget” and “solvency level”. It is also going to depend on the relative importance placed on “contribution stabilisation” versus looking through to the true economic position which will ultimately not change over the long-term.
Anyway, with a number of members of the Bhagwan household struck down with flu, and so “daddy duties” calling, I am not going to get the time tonight to give this topic the detailed analysis it deserves.
I hope the introduction into the local debate of what has happened across the Atlantic may serve as further food for thought and discussion over the coming days.
Finally, if the “LDI” market doesn’t have enough to contend with following this announcement then perhaps you will indulge me introducing two further "tail risk" variables which we may need to contend with come autumn 2014 - now that's what I call thinking ahead!
Those variables arise out of the possibility of a "yes" vote for Scottish independence in 2014. See article below by Mark Allan of AXA IM.
In particular, the possibility of gilts being retired and replaced by new Scottish issues as well as the size of Scottish banks vs. Scottish GDP. I think if I were “long" a diversified portfolio of OTC LDI hedges via a range of the common LDI banking counterparties, I wouldn’t want to have to deal with the additional complication of a positive vote for Scottish independence and what this may mean for my counterparty credit risk on some of those. If the vote takes place in late November, then perhaps we could conjure up a string of wins for the Scottish rugby team in the autumn 2014 internationals in the hope that the resulting boost to national pride will quell any desire to express that pride at the polls and hence preserve the unity of the Kingdom.
So much for winding down for Christmas, huh? Talking of Christmas, perhaps Santa has a truckload of goodies for all those naughty pension schemes who haven’t been hedging?
Tweet Letter to congress TW Funding relief AHEK MAP 21 Scottish independence SOA Funding Relief
