Sir,
Your recent correspondence on longevity bonds is driven by the underlying belief that increasing mortality rates (along with the failure of actuaries to spot them in time) are the single greatest cause of the funding crisis in UK defined benefit pension schemes.
Not so. The greatest villain has been the decline in the gap between gilt yields and inflation, which has dropped from 480 basis points in July 1995 to below 100 now. Long-dated index-linked gilts currently yield 100 basis points or less.
Pension fund deficits are usually reported on a "buy-out" analysis, assuming the fund is closed, with amounts available buying annuities for members. Regrettably, headlines tend to focus on this measure, since the eye-popping deficits produced by buy-out analysis are more newsworthy. The more relevant (if more prosaic) "ongoing" analysis produces smaller calculated deficits, or even surpluses.
Low levels of gilt yields are due, first, to the chancellor's handling of the economy, wringing out long-term expectations of inflation; and second, to an unwillingness to issue many long-dated gilts, funding the public sector borrowing requirement primarily with short-term borrowings.
As pension funds shift from equities to bonds, a surplus of demand over supply arises and the gilt yield drops steeply. The large part of the increase in pension fund buy-out "deficits" is due to this drop: the Treasury's propensity to "fund short" is estimated to have reduced gilt yields by between 50 and 100 basis points or more, fuelling the current "deficit" crisis.
The Treasury faces a Catch-22 situation. It would be terrific for our nation's finances if more long bonds could be issued, substituting for volatile short-term debt. But when the Treasury considers this, it is told there is not a huge appetite for long bonds at current yields, so issuance would be dangerous. Lack of demand could lead to a failed issuance - with the potential for weighty editorials bemoaning financial mismanagement. So the Treasury issues long bonds only cautiously and in small quantities. Lack of demand is not remarkable at a yield of 1 per cent or less.
And yet, if the issuance yield were 2 or even 3 per cent, the borrowings would still be very cheap for the government. The way to square this circle is for the government to have a large Dutch auction of long-dated gilts, whose pricing mechanism would ensure that all bonds are sold, but at a clearing, rather than a pre-determined, price. The Treasury would see the rate for long-dated gilts rise, but at prices still lower than in short-term markets. The funding level of private-sector pension schemes would improve dramatically. The Treasury would be hailed for solving a large part of the pensions crisis.
Jon Moynihan
Executive Chairman
PA Consulting Group
London SW1W 9SR
