Category / Inflation

Eurovision and redenomination risk February 17, 2014 at 10:14 pm

Coming quickly behind the news that Scotland can’t have the pound, nor join the EU, should it pick independence, comes an even bigger worry for the Yes campaign:

Scotland’s bid to join Eurovision would be opposed by countries where people can hear, it has been claimed.

As so often, the Daily Mash is your source here. Still, at least all those lawyers trying to figure out what to do with thirty year inflation swaps sold to Scottish pension funds and now referencing an irrelevant inflation rate and settling in the wrong currency can listen to the radio without the risk of hearing bagpipes.

Demanding answers March 15, 2012 at 7:07 am

From The Money Illusion, via Brad DeLong:

In late 2008 the markets were telling us that the Fed was making a tragic mistake by allowing NGDP expectations to plunge. But the economics profession didn’t listen, as they view stock investors as being irrational. Economists were obsessed with the notion that the real problem was banking distress, and that fixing banking would fix the problem. No, the real problem wasn’t banking, the real problem was nominal.

That goes a little far for me – it’s pretty hard to have rising aggregate demand if the credit supply is falling due to a broken banking system (and in particular a broken transmission mechanism) – but there is more than a grain of truth to this.

Starter savings accounts February 18, 2012 at 5:26 pm

From Steve Randy Waldman at Interfluidity, a typically intriguing and thoughtful post:

The Federal government should offer inflation-protected savings accounts to individual citizens, but with a strict size limit of, say, $200,000. These accounts would work like bank savings accounts, and might even be administered by banks. But deposits would be advanced directly to the government (reducing borrowing by the Treasury), and the government would be responsible for repayment. The accounts would promise a tax-free real interest rate of 0% on balances up to the limit. Each month, accounts would be credited with interest based on the most recent increase in the Consumer Price Index (adjusted for any revisions to estimates for previous months).

For me, there are two things really right with this idea. First, it creates a new class of safe asset for folks would cannot easily buy inflation-linked bonds. Second, it funds the government in a way that (like the issuance of linkers) creates an incentive not to let inflation run rampant. [This means, as SRW points out, that you would want to keep the total notional constrained - he suggests 25% of GDP.]

There is one thing that worries me slightly though, and that is the drain that this would cause on bank deposits. Right now deposit insurance means that the banking system receives retail funding without retail investors taking risk. This is good: it funds credit to the rest of the economy, while not exposing ordinary depositors to a risk they would find hard to assess. But starter savings accounts would compete directly with bank deposits: their presence would undoubtedly cause substantial falls in insured deposits at a time when we are trying to encourage banks to fund themselves via deposits (rather than via CP, or repo, or other risky sources). If the net effect of starter savings accounts is for the government to raise expensive money which it then has to lend to the banking system cheaply (because the discount window rate is less than inflation), then they might be a bit of an own goal…

Still, this is a good idea and it definitely deserves further study.

Who pays? May 13, 2011 at 7:34 am

Why rob a bank?

Because that is where the money is.

That’s Sutton’s law, and a lot of sense it makes too. So, if you are a sovereign without enough money, who do you go to? Someone with money.

This means that there are only a limited number of choices for solving the endebtedness problem in advanced nations. Your choices are one or more of:

  • Individual taxpayers;
  • Individual consumers;
  • Corporate taxpayers;
  • Corporate consumers;
  • Government bond holders;
  • Foreigners.

The last won’t work for ever; you can’t keep increasing your borrowing as a percentage of GDP. Sovereign default or restructuring works, but it stops you from being able to borrow again for some time. Thus central bankers often think that you have to bear most of the burden internally. That makes it a pain allocation problem. Increase taxes; decrease services: these things are unpopular.

Reinhart and Sbrancia point out an interesting mechanism that allows governments to give some of the pain to bond holders without the stigma of a hard restructuring. From their abstract:

A subtle type of debt restructuring takes the form of “financial
repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks… Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.

Think of this as a subtle form of taxation. By providing negative real returns, governments can slowly take money from bond holders. Of course solving a government endebtedness problem this way also requires spending to grow less slowly than inflation, which is difficult. But it does provide a mechanism which many advanced nations will find attractive. The Bond Vigilantes don’t think we are there yet. But I suspect that we will be in due course.

Policy on the asset side again March 13, 2011 at 9:57 am

The FT last week had an article about exactly what I meant in my earlier post. They said:

UK pension funds are urging the government to issue more long-dated and inflation-protected gilts to help them deal with increasing life expectancy of members and regulations that put pressure on the to “de-risk” investments”

The result of not acceding to this request is clear: without a supply of the real thing, banks will attempt to create it using a combination of swaps, credit derivatives, and whatever bonds they can find. Meanwhile long dated gilt yields, both nominal and real will be lower than market levels due to unmet demand. This is not a good situation: it leaves pension funds with both more basis risk and more counterparty risk than they need, and it leaves pensioners with less return. The DMO should not just be saying ‘how many long-dated gilts do we need to issue?’ but rather ‘how many does the market want?’.

Update. Here is another example of the same phenomena, from a discussion by Bronte Capital of 77 bank in Japan.

In a world where banks everywhere are short of capital 77 bank is swimming in it. [Their Tier 1 ratio was over 12%.] … This bank has an embarrassment of riches – and nothing to do with them.

As John suggests, Japan is a great example of what happens if you keep rates low to ‘save’ the banking system and pay no attention to the needs of investors. Capital sits in places like 77 doing nothing rather than being distributed to economically productive users of it. And that is bad for everyone.

Policy on the Asset side March 5, 2011 at 12:13 pm

The standard account of the financial system is about capital allocation. It starts from the premise that there are people who need capital – companies, individuals, whoever – and the job of the financial system is to give it to those who (in some sense) deserve it at the right price. In other words, it concentrates on the liability side: the assets available are simply those that result from capital being given to those that want it, and there is no attention given to whether those assets are in some sense the right ones.

One of the good things about the Marxist analysis of capitalism (and reader beware because I haven’t actually read any Marx) is that it also has something to say about the asset side. In particular Marx (at least as he is construed these days) identifies the problem of over-financialization. One way of reading this is an excess of investable capital versus the opportunities available. In other words, hot money looking for a home.

This suggests that a legitimate goal of economic policy is not just to ensure that those that want money can get, but also that there are assets available for those that want them. To some extent, the UK is ahead of the curve here: at least we issue a significant amount of inflation-linked debt to help meet the needs of pension funds. But we could certainly do more. Willem Buiter has argued in the past that one of the causes of the credit crunch was a wave of money from the fast-growing BRICs countries and from baby boomer generation pensions investment looking for a safe home. The structured finance industry diligently provided one; AAA rated ABS. Now, that didn’t turn out to be so safe, so we certainly cannot rely on the markets alone to generate the types of assets that investors want. Indeed the situation today is even worse: few feel good about equity valuations, many commodities are clearly overbought, emerging markets look seriously bubbly, and long term bond yields in major currencies seem rather likely to go up. So what’s left? Private equity? Utilities? Short term bonds while you wait for yields to rise?

So… why not a massive extension of National Savings? Instead of simply providing small investments, this new, beefier National Investments and Pensions organisation (‘Be Nippy with your Money’) would offer a pension wrapper too, with products including term deposits, inflation linked bonds, government underwritten equity participation products, and such like. It would be illegal not to offer its product as an alternative to a private pension scheme, and due to its massive size, it could offer a very low fee structure. It would keep it simple – index tracker products, bond plus call structures, that kind of thing – and of course it would provide tax advantaged accounts like ISAs. Whatever money it raised would replace capital markets gilts issuance, and it would have the mandate to offer the products that savers wanted.

Unwarranted restructuring November 30, 2010 at 8:17 am

Prisoner of Restructuring

Brendan Moynihan (no, not Brian Lenihan) has an interesting suggestion for Eurozone debt restructuring on Bloomberg:

European countries should reduce the principal amount they owe by issuing gross domestic product-linked sovereign bonds as an incentive to creditors to take a haircut on the debt. Bondholders would accept, say, 70 cents on the dollar on their bonds and receive new debt paying the German bund rate and with a warrant that pays a coupon tied to the amount each country’s respective GDP exceeds, say, 2 percent. The warrants could have an assigned value at inception — based on a long-term call option on GDP — and be detachable and traded separately.

This is like a debt-for-converts swap. Existing bond holders are offered new bonds plus the warrants. If the warrants are long dated enough, you can reduce the principal sufficiently that the burden of payment drops signifcantly. A 30% haircut, as Brian suggests, is perfectly possible.

The problem, though, is that the warrants would be really attractive to hedge funds only if they were hedgeable, and you can’t short GDP easily. I wonder if inflation is a reasonable proxy. If instead the warrants paid out based on ten year cumulative inflation, then dealers could hedged using inflation-linked bonds, and the effect might be similar. This would also likely have the desirable side effect of making the linker market more liquid and hence decreasing linker issuer costs for governments. (I have not had time to look at inflation volatility and price up the option, but given the forward inflation curve is quite steep I imagine the maths could be made to work.)

Update. I couldn’t resist pricing up the warrant (which in itself wasn’t easy – you have to think hard about the replicating portfolio to get the right answer), and with a plausible HICP vol a 2% strike 10 year inflation warrant does indeed come out as being worth 30%. So the trade described above passes at least the first sanity check…

Pensions and the deficit September 27, 2010 at 1:28 pm

I didn’t catch this, but Jonathan Hopkin did. Julie Finch has the original suggestion in the Observer. Hopkin comments on her article

high earners in Britain receive enormous tax relief on their private pensions, estimated by Richard Murphy to be worth £38 billion per year, about a quarter of the deficit. [Julie] suggests that ‘we should maintain the subsidy, but only if the recipients divert at least a proportion of their funds into infrastructure investments and local authority bonds’.

Sounds good to me. In fact, why stop at that? The subsidy could be tied to the purchase of Treasury bonds at rates close to the rate of inflation. After all, the deficit is at least in part the consequence of saving the value of private investments through state intervention. Financing government borrowing at a reasonable rate seems a fair contribution from those who have benefited so much. This would remove fears of a spike in bond prices, allowing us to plan for an orderly reduction of the deficit over a longer period of time.

Absolutely. This would also have the side effect of reducing asset price bubbles and the inevitable clamour when pensioners lose money on (highly risky) equity investments. How about a requirement to invest a minimum of half of your pension in long-dated linkers?

Inefficient markets and inflation-linked bonds August 15, 2010 at 1:54 pm

There has been predictable hullabaloo about negative TIPs yields. The more balanced end of the spectrum is this from Reuters

Investors are betting that inflation rate will rise, fattening the return on the securities and making up for the negative yield.

Or this from Seeking Alpha:

Why is the real yield negative? There are two main reasons.

  1. Liquidity crisis – TIPS investors are afraid and looking for safety and liquidity at any price.
  2. Inflation Expectations – The 5-Year Treasury yield is now 2.43%, so the implied inflation rate priced into the 5-Year TIPS is about 2.61% annually. This is higher than the Fed’s target inflation rate. The TIPS market is saying that the Fed is under-estimating future CPI inflation.

What’s actually going on then?

The only thing we can really deduce is that there are a lot of buyers of TIPS. What we can’t easily deduce from the TIPS yield right now is forward US inflation. Why? Well first because the argument that allows us to derive inflation from TIPS yields depends on the financing cost of nominal treasuries and linkers being the same. Right now TIPS are scarce and you cannot repo them in as easily as nominal treasuries. (This is because of retail demand, plus linkers being asset swapped to provide inflation legs against inflation swaps to pension funds.) Second, TIPS have a zero floor, so you have to option adjust the bond, but figuring out the vol to use for the option isn’t easy as there are no linkers out there without the floor and the market in inflation options is thin to say the least. (With inflation at 3% and with low inflation vol, the floor was pretty much worthless so people used to ignore it. That is no longer true.)

The first point above, then, is probably true. But don’t get carried away in thinking that the TIPS yield tells you much about inflation expectations until you have at least figured out how to account for the liquidity premium, financing and OIS effects.

How much stimulus can technology absorb? July 18, 2010 at 6:06 am

Here’s an interesting conjecture from the Futurist. First he points out that we have had a massive stimulus, yet this has not lead to inflation. Remember, $1T of liquidity and an essentially zero FED funds rate have not lead to any prospect of inflation. Now you all I am sure know the conventional explanations of this, but bear with the Futurist while he gives you a novel one.

A technology company exists under the reality that all inventory depreciates very quickly (at over 10% per quarter in many cases), and that price drops will shrink revenues unless unit sales rise enough to offset it (and assuming that enough unit inventory was even produced). This results in the constant pressure to create new and improved products every few months just to occupy prime price points, without which revenues would plunge within just a year. Yet, high-tech companies have built hugely profitable businesses around these peculiar challenges, and at least 8 such US companies have market capitalizations over $100 Billion. 6 of those 8 are headquartered in Silicon Valley.

Now, here is the point to ponder : We have never had a significant technology sector while also facing the fears (warranted or otherwise) of high inflation. When high inflation vanished in 1982, the technology sector was too tiny to be considered a significant contributor to macroeconomic statistics. In an environment of high inflation combined with a large technology industry, however, major consumer retail pricepoints, such as $99.99 or $199.99, become more affordable. The same also applies to enterprise-class customers. Thus, demand creeps upwards even as cost to produce the products goes down on the same Impact of Computing curve. This allows a technology company the ability to postpone price drops and expand margins, or to sell more volume at the same nominal dollar price. Hence, higher inflation causes the revenues and/or margins of technology companies to rise, which means their earnings-per-share certainly surges.

So what we are seeing is the gigantic amount of liquidity created by the Federal Reserve is instead cycling through technology companies and increasing their earnings. The products they sell, in turn, increase productivity and promptly push inflation back down. Every uptick in inflation merely guarantees its own pushback, and the 1.5% of GDP that mops up all the liquidity and creates this form of ‘good’ deflation can be termed as the ‘Techno-Sponge’. So how much liquidity can the Techno-Sponge absorb before saturation?

Now I have no idea whether this is even half way to true. But it is an interesting idea. Certainly tech spending, unlike magnums of Krug (so déclassé – I prefer Salon), can increase productivity. If that creates more wealth, then you can have growth without inflation, especially if the basket that defines inflation is tech heavy.

Let’s get all of those worries about inflation in perspective May 27, 2009 at 8:25 pm


Hat tip the Guardian data blog.

Update. Krugman’s take is here. The one line summary: does the big inflation scare make any sense? Basically, no.

What I don’t understand about the DMO December 8, 2008 at 7:19 am

FT alphaville has a post on the DMO at the tail end of last week, setting out the auction catalogue for the next quarter and setting out progress to date. It includes this summary of the year so far:

Gilt sales vs. remit

This squares with my understanding that the DMO has a policy to keep index linked issuance at less than 20% of the total. My question is why. There is massive demand for long-dated linkers from pension funds and life insurers. Given the need to sell a lot – really a lot – of gilts next year, why is the DMO not giving the market what it actually wants to buy?

A short note on the yield of inflation-linked bonds December 4, 2008 at 9:40 am

Some people recently seem confused by the yield of some inflation linked bonds. Here’s the scoop.

1. Some, but not all, inflation linked bonds are floored at zero inflation on principal. That is, you cannot get less than the face value back. TIPS, for instance, have this feature.

(2. There is a more extreme form of flooring where the coupon is floored at the stated real yield on the face, so for instance if you hold a 2.5% real yield bond where the face has accrued to $1M, then you will always get a coupon of at least $25,000. This form of floor is rare, so I will ignore it.)

3. This means that in effect these floored bonds are a pure inflation-linked bond together with a floor. The strike of the floor depends on inflation to date. To see this, suppose we have an old TIPS. Experienced inflation over its life will have inflated its market price way above par. Thus inflation has to be highly negative for the floor to be worth anything. For a newly issued TIPS, on the other hand, the floor is much closer to the money.

4. When inflation was expected to be 3 or 4% a year, this didn’t really matter much. But with deflation expected in 2009 by some, you really need to adjust the yield of short dated newly issued floored bonds by the value of the embedded inflation floor, as this floor is now quite valuable.

5. This is in theory a simple option adjusted spread problem. I say in theory because in some markets – the UK is a good example – there is an oversupply of inflation caps which means that market quoted inflation volatilities are not reliable. But this isn’t an issue for TIPS. Simply [;-)] go to your friendly broker, get a quote for the correct strike inflation floor, back out the vol, then use this to option adjust the spread of your bond.

No arbitrage requires arbitrageurs November 20, 2008 at 6:14 am

No arbitrage conditions are not natural laws. You can only rely on them if there are enough arbitrageurs around to keep the markets in line. At the moment, that isn’t true in many settings. John Dizard points out an example from the Tips market:

seven-year Tips bonds are asset swapping at 130 basis points over Libor

As Dizard says, this is partly because the Tips are illiquid and hard to finance (and thus to leverage), and partly because there is not enough risk capital around:

The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds. The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry, and then were sold off by merciless prime brokers.

Dismally bad August 19, 2008 at 7:55 am

Larry Elliott in the Guardian has an article encouraging the Bank of England to cut rates. Larry is harsh with the Bank, accusing them of being asleep at the wheel, and he presents as evidence the Bank’s 2007 CPI prediction:

CPI projection 2007

This shows a zero chance of inflation reaching 5% in 2008. If we now turn to the latest report, we find:

CPI projection 2008

In other words, current CPI over 5% and likely to stay there for six months. For me this is not proof of the Bank’s guilt: this is just proof of how utterly unscientific economics is. After all, the Bank of England staff are neither ignorant nor lazy. They will have applied reasonable econometric tools in reasonable ways to get the first chart. The fact that reality turned out not just different from their prediction but completely outside the error bars simply shows that far too often when tested against reality, economics fails dismally.

Update. See here for a comprehensive account of the failure of economics. Or at least its failure to be funny.

Trichet on asset price bubbles May 23, 2008 at 8:48 am

Jean-Claude Trichet made a speech in 2005 on Asset Price Bubbles and Monetary Policy. The full text is here. A few points leap out at me. Firstly Trichet raises the question as to whether there is such a thing as an asset price bubble:

I believe the NASDAQ valuation of the late 1990s was not excessive… [I] tend to believe that occasionally we observe behavioural patterns in financial markets, which can even be perfectly compatible with rationality from an individual investor’s perspective, but nevertheless lead to possibly large and increasing deviations of asset prices from their fundamental values, until the fragile edifice crumbles.

`Excessive’ is a difficult word and I can see why Trichet is cautious about using it. But certainly the fair value of debt securities is the result of many phenomena including funding premiums and liquidity premiums as well as long term default rates. Their spread can tighten leading to asset price growth if funding is cheap and liquidity is plentiful without this necessarily being irrational.

The problem knowing how much is too much means that Trichet is cautious about the possibility of identifying an asset price bubble:

I would argue that, yes, bubbles do exist, but that it is very hard to identify them with certainty and almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not.

He suggests one definition of a bubble:

[There is] a warning signal when both the credit-to-income ratio and real aggregate asset prices simultaneously deviate from their trends by 4 percentage points and 40% respectively.

I agree, but I would have thought that liquidity and/or funding premiums and the availability of credit would also provide helpful warning signals. As Trichet says:

A bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.

Interestingly (for 2005) Trichet points out the positive feedback in a bubble pricking of collateral:

A negative shock is likely to have a larger effect than a positive one. The reasons are that credit constraints can depend on the value of collateral and that in case of a financial crisis the whole financial intermediation process can in the worst case completely fail.

After those insights the conclusions are depressing:

With regard to the optimal monetary policy response to asset price bubbles, I would argue that its informational requirements and its possible – and difficult to assess – side-effects are in reality very onerous. Empirical evidence confirms the link between money and credit developments and asset price booms. Thus, a comprehensive monetary analysis will detect those risks to medium and long-run price stability…

I fully advocate the transparency of a central bank’s assessment of risks to financial stability and of its strategic thinking on asset price bubbles and monetary policy. The fact that our monetary analysis uses a comprehensive assessment of the liquidity situation that may, under certain circumstances, provide early information on developing financial instability is an important element in this endeavour.

In other words we will try to tell you when a bubble is inflating but, beyond targeting inflation, there is little we are going to do about it. And M. Trichet did indeed keep to the second part of that promise.

All Inflation’s Little Parts May 10, 2008 at 3:07 pm

A wonderful graphic from the NYT illustrates the US inflation basket. The original interactive version is here: the static version is below.

The Parts of Inflation

(Click for a larger version.)

Will inflation be targeted? May 1, 2008 at 7:58 pm

Central banks have over the last few years been either rather successful at inflation targeting or rather lucky that inflation has remained low (but positive). FT alphaville cites some research from Morgan Stanley questioning whether this happy state will persist.

For me there are two parts to this question. Does inflation targeting work? And if it does, will central banks actually practice it?

On the first certainly when inflation has been rising in the major economies recently raising rates seems to have reined in inflation. However we have not really seriously flirted with a deflationary environment so the evidence concerning raising a too-low inflation rate is scanty. But that was definitely an issue in Japan: with rates close to zero they had nowhere to go if the only policy tool is control of the short rate. The efficacy of targeting therefore gets a ‘not proven’ from me.

The second point is more problematic. The FED, for instance, seems to have abandoned inflation targeting entirely in order to protect the financial system. When you consider the manipulation of the inflation index in the US (the official inflation figure is now known to some as ‘inflation ex-inflation’ – see here for an independent calculation) this response becomes even more troubling. So it seems that central banks will target inflation only if there is not something more important they need to use short rates for.

Three balls in Frankfurt and New York: a Decade of Deflation? February 20, 2008 at 8:51 am

The FT has a story reminding us that the FED is currently playing a game of ‘go on, I’ll trust you, how much do you want for that?’ that would shame a small town pawn shop.

The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.

The ECB has similar tactics:

Eurozone banks increased sharply their use of mortgage-backed debt and similar structured bonds last year in order to raise money from the European Central Bank, helping to avoid liquidity problems in financial markets.

The volume of asset-backed securities pledged as collateral in ECB market operations to provide funding to banks reached €215bn ($315bn) by the end of last September, the bank said in data released on Thursday.

It is worth remembering that this massive liquifaction of the banking system was one of the key features of Japanese economic policy during the decade of deflation. The central banks are playing a very dangerous game here and it cannot last for many more months without addicting the banks to cheap funds and very low liquidity premiums – an addiction the Japanese example shows is very difficult to recover from.

Update.Credit slips has an interesting if perhaps overly bearish macroeconomic perspective on the potential for an extended period of deflation.

Wearing a cap January 7, 2008 at 1:18 pm

Further to the discussion on Saturday, here are some more thoughts on risks in pensions and who should bear them.

Pensions are complicated things. Consider a typical defined benefit scheme. Here the pensioner has a right to a certain level of pension – often index linked – and the employer has an obligation to provide it. The pension is simply collateral against that obligation.

The first risk, then, is that the employer cannot meet that obligation, typically because they have defaulted, and the pension fund is not adequate. It is this risk that pensions protection legislation is meant to address.

The second risk is that the fund is not judged be adequate to meet the employer’s liability, causing the need to ‘top up’ the fund. I say ‘is not judged to be’ rather than ‘is not’ because the law requires an assessment of the future likelihood of adequacy to be made rather than a spot assessment. Ignoring for a moment the veracity of the assessment – which is questionable – let’s look at how a fund might fail to be sufficient to meet an employer’s liabilities.

There are two moving parts here: the fund assets, and the fund liabilities. Funds are typically invested in some or all of corporate bonds, equities, and inflation linked bonds, plus perhaps other asset classes. Therefore they are typically:

  • Short credit spreads (if credit spreads increase, the fund loses money on a MTM basis);
  • Short nominal rates (because if rates increase, fixed rate bonds are worth less);
  • Long equities; and
  • Long CPI inflation (to the extent that they hold inflation-linked assets).

On the liability side the fund is:

  • Short longevity (if people live longer it has to pay a pension for longer and hence loses money);
  • Short wage inflation (if final salaries increase, so do pensions);
  • Short CPI inflation (if inflation increases, so do index-linked pensions);
  • Long nominal rates (because future liabilities are discounted back to today along some interest rate curve).

The risk is then that the spread assets – liabilities goes negative. In a DB scheme then the employer has to top up a fund if this spread falls beneath some threshold value, and hence they are short an option on the spread. In a defined contribution (‘DC’) scheme the pensioner bears all the risk and hence they are short this complicated spread cap: if their funds don’t meet their pension expectations, then they have to find the cash for their retirement from somewhere else.

The details of the cap in any particular situation of course depend on how funds are invested, but typically it will have some elements of equity risk, interest rate risk, corporate credit spread risk, and both wage and CPI inflation risk, together with the risk of the comovement of these factors (which you can simplistically think of as correlation risk). Given it is a very long dated instrument – perhaps as much as ninety years for someone entering the workforce now – and very complicated, it is hardly a surprise that it is difficult to know what it is worth.

Note in particular that because we have a long-dated problem, the details of the dynamics of each component of the spread are crucial. It might be reasonable to assume that some of them, such as corporate credit spreads, are mean reverting. This makes the problem easier. For others, notably inflation and equity returns, there seems no reason at all to assume long term mean reversion. This means there is an awful lot of model risk in pensions analysis.

Some dimensions of pensions risk can be minimised: for instance if the scheme holds inflation linked gilts then it can hedged inflation risk and bears no equity risk. However it still have longevity risk, and (absent a liquid longevity swap market anyway) contingent inflation risk (since if longevity increases the fund is mismatched on the duration of its assets vs. its liabilities and hence has inflation term structure risk). Moreover, of course, a low risk pension fund has to be much more comprehensively funded than one that is taking market risk in multiple dimensions (equities, corporate credit, property, alternative investments, …) Finally note that longevity risk is remarked considerably less often than other risk components so it is less visible – but that does not mean that it is not there.

The key policy question, then, in pension is who should bear the risk of underfunding, i.e. who should write the spread cap. Recently, there has been a suggestion that rather than one party bearing all of the risk as in current DB and DC schemes, perhaps it should be shared between employers, employees, perhaps with a far out of the money state backstop*. (See here for a further discussion.)

This is certainly a policy option that could be considered. Pensions policy is bedeviled by a failure to address risk issues openly, not least because most pensioners do not want to face the harsh reality that either a pension has significant risk or it is extremely costly to fund. Education is needed to address this point. Once we are ready for the debate, though, I would suggest there is room for a creative sharing of risk. There are no easy options here, not least because of the considerable uncertainty in estimating the size of the risk. But the problem is hard enough without artificially restricting the domain of possible solutions.

*One issue not addressed here is the use of DC schemes to reduce employer contributions. DC does not imply lesser employer contributions and legislation could (and probably should) stop employers using DC as a way of reducing their funding obligations.