Amortising Bonds and Sovereign Annuities

Details of the today’s sale of “amortising bonds” by the NTMA are available here.   See here for the “information memorandum”.  The NTMA statement announcing the intention to sell the bonds in response to demands following the annoucement of the revised Pensions Board funding standard is here.

The new bonds will facilitate the development of “sovereign annuities”.   While there is no easy answer to the funding crisis in defined-benefit pension schemes, risks placed on pensioners through default risk on sovereign bonds should not be neglected. 

A briefing statement on sovereign annuities from the The Society of Actuaries in Ireland is available here.   Guidance to trustees and providers of sovereign of annuities is available from this Pensions Board link (see Related Documents).  A FAQ on the revised funding standard is available here.

44 thoughts on “Amortising Bonds and Sovereign Annuities”

  1. “While there is no easy answer to the funding crisis in defined-benefit pension schemes, risks placed on pensioners through default risk on sovereign bonds should not be neglected.”

    +1

  2. It looks as though the whole pensions industry needs someone with a bit of cop on to come in and sort it out. Requiring actuaries to value liabilities 40 and 50 years out based on rock bottom bond rates is nuts. The reason bond rates are so low is because the global financial system is still in intensive care. It shouldn’t mean that every single DB scheme has to be shut down and the members exposed to the lunacy of DC risk.

    The whole financial system in Ireland needs an overhaul. Neoliberal principles are not going to cut the mustard and get the country going again. It’s a pity there aren’t people of the calibre of Horace Plunkett or Michael Davitt around to look at the bigger picture and see the opportunities.

    Tull’s post about Bank of Ireland- return on assets of 0.5% pre writeoffs- what is the point of Bank of Ireland? Would it not make more sense for a core group of depositors to take their money out and start a new bank and let the ECB take the hit ? If the Bnk of Ireland could compete for business, let it compete, otherwise forget it. Is there no way to get credit to where it is needed in the SME sector?

  3. I am no bond expert but are the longer maturities not mispriced. Yields should be higher for longer term.

    Seafoid,
    If you know anybody with a spare billion in equity please contact me. I would be willing to run a new bank for a modest salary – say 259k. I would hire BEB as head of treasury. Anybody got the squids number.

  4. @Tullmcadoo – Currently in the Eurozone there are two inverted yield curves i.e. where longer rates are below shorter – these are in Greece and Portugal. They reflect haircut risk (the Irish curve was itself inverted for a considerable part of 2011).

    They are upward sloping in other countries, but tend to flatten past 20 years. This trend is not so marked in those countries with negative short term yields – have investors in these countries never heard of current accounts? – but in general one cannot say that the longer the term the higher the yield should be, no matter how instinctively correct that assumption may seem.

  5. A,
    My Bloomberg tells me there is still some small incline in 10s – long bonds. What does that tell us. Policy is too tight or that there is no liquidity in the longs and they are mispriced?

  6. @ Tull

    1. Bonds were sold slightly ‘rich’ for investors (maybe 15-20bps), cos the NTMA knew the pension funds wanted this structure in terms of amortisation and ultra-long maturity, and the fact that the alternatives of 1.35% 10 year Bunds is so deeply unattractive.

    2. My CV is in the post.

  7. Does the German “be off with you” reported in the paper today re a restructuring of the Anglo debt not throw open ye whole gate of default again?

  8. These things are always accompanied by a whole lot of hand waving such as “default risk on sovereign bonds should not be neglected”.

    Well, AFAIK, according to Sovency II, there will be a zero risk-weight for local government debt, so the European insurance regulator thinks it can be neglected. To do otherwise would be to destroy the market for BTPs as most Italian insurers would then be forced to invest abroad. Japan too has a long history of the regulator supporting the sovereign, not to mention post-war Britian and the US.

    I know “supporting the sovereign” is also known as financial repression. But financial crises are not caused overnight and are often preceded by long bubble-like periods where pension funds and savers could achieve disproportionate returns. For this reason, if a default does occur, it is probably desirable that DB funds take a hit. As one of the commentators on FTAV says, if default occurs, then the solvency or not of pension funds will be down the list of national priorities.

  9. Why cant pensioners get the option of a guaranteed normal annuity with reduced benefits?

    Anyone?????

  10. Seafóid,

    “It shouldn’t mean that every single DB scheme has to be shut down and the members exposed to the lunacy of DC risk.”

    Talk to waterford crystal workers (just 1 example from many) of the lunacy of DB risk – its a lot riskier than DC.

    “Requiring actuaries to value liabilities 40 and 50 years out based on rock bottom bond rates is nuts.”

    This only applies to pensioner liabilities (maybe 50% of a typical scheme). The rest valued at risk free rates plus 5% or so (actually 7% fixed). Overall the discount rate averages 4-5% – doesnt seem to low to me.

    “The reason bond rates are so low is because the global financial system is still in intensive care.”

    Probably should stick a “in my opinion” in that sentence.

  11. The fact that the myth that DB is way better than DC still exists is astounding to me.

    Properly funded DC >>>>>>>> DB and anyone who thinks differently doesnt know what they are talking about.

  12. I should have clarified that last comment – obviously if you are in the pensions industry (like myself)

    DB >>>> DC

    Not coincidentally

    DB Fees >>>>> DC Fees

  13. Herr Schauble

    “We will have to avoid generating a headline like ‘Aid programme for Ireland topped up’, because then investors in California or Shanghai might not understand that this top- up is a reward for Ireland, but might be tempted to conclude that what was agreed two years ago for Ireland was not enough. And that is surely not what we want.”

    Good love those poor eejits in the market…and isn’t it great how considerate Schaubbie is in not wanting to do anything that might confuse them or require them to use a bit of grey matter.

    Did you ever hear such condescending disjointed jibberish in all your life. It reminds me of those Newstalk interviews that Henry McKean does with Kids to get their take on events in the world.

  14. Tullmcadoo…

    1. Risk – DB schemes are not defined benefit!!!! They are basically “defined benefit if things go well” DC you get defined contribution and guess what – you get what they say you get!

    2. Diversification – dont put all your eggs in the employer basket – lots of people lose their job and their db scheme is f**ked in the one go (waterford crystal)

    3. Flexibility – DC schemes are much more flexible than DB

    4. Sovereign annuities – from now on any Trustee can purchase a sovereign annuity in place of your guaranteed benefit

    DC is only better than a DB when it is properly funded. Lots of Employers have DC schemes with “contributions” defined as zero.

    A 15% DC scheme (say 10% Employer 5% employee) is a much better bet than a typical 60ths DB scheme with a 5% member contribution

  15. @ Annuity

    Lets say you work for private corporate ABC Ltd. They are not a bank or a semi state, but are reaonably healthy and profitable and seem to have a good future ahead of them. They offer you a choice between DC and DB pension schemes. Which do you choose? Ignoring the default risk ( a real risk to be sure), which is more attractive to most people? How do u put a value on the default risk?

  16. Actuary,
    I take your point DB > DC if your employer has a rock solid balance sheet & cash flow, you have a long term contract. Failing that if your employer is in the public sector or still behaves as of it is- Aer Lingus perhaps-you are oxo.

  17. @Actuary

    DC schemes expose the punter to investment risk that was previously borne by the employer. All things being equal DB is better for the employee from that point of view. Waterford crystal is the DB bogeyman but dumb DC money gets suckered especially at times like these.

    Should social security be invested in the stockmarket ?

    Leavers got poor value alright but employers put more into DB than they will into DC. It’s all part of the trend of passing on as much risk as possible to the individual.

  18. @Actuary
    Re your question about reduced benefits

    I think the big risk is inflation.

    Every so often the Fear gauge goes above 40 and that’s when the pros can’t agree on whether or not it will be extend and pretend redux or hello inflation.

    Bonds are not going to get another 10 years of the bull market imo and when TSHTF inflation is very likely. That will diminish the real value of annuity payouts based on bunds or whatever.

    I saw there last week that Aviva investors put money into a windfarm in spain rather than get nothing on bunds or gilts.

    Pensioners should have choices -if those of a more conservative bent want a much reduced annuity in CHF let them have it. But those who think a 5% return is reasonable should have the option of an annuity built around viable investment.

  19. DC schemes expose investors to risk of investment mismanagement, to be borne by the contributor alone. DB schemes expose, firstly, the employer to this risk. Such investment mismanagement has occurred, but it is probably not fair to leave the blame for this at the door exclusively of trustees or fund managers.

    The over- and mis-allocation to equities, at ever inflated multiples, effectively forced by actuaries/pension fund advisors, in the period 1997/2007 defies comprehension.

    The incidence and scale of fund mismanagement through misallocation has greatly dwarfed the incidence and scale of sovereign default in the last 15, 20, and 50 years.

  20. My last point on this.

    For all the talk of companys with rock solid balance sheets DB schemes being better just remember you need it to be rock solid for 80 years if you are now 25!

    Also in ireland the employer can (and has on loads of examples (google element 6) default on promises even if it has the money!

    I will take my chance with DC. If I was in UK I would say DB because they have a law forbidding companys walking away and they have an insurance scheme for double insolvency (scheme and company go bust)

  21. @ Actuary

    good point about the legal system. Ireland is so poor for legal protection for the citizen.

    Of course there is lots of law around drink.

    @ aiman

    I wouldn’t say it defied comprehension. There used to be blue chip banks and you couldn’t lose money on them.
    Even amongst the economics gurus who called the crash ? Who stood up when they were floating the Building societies and said there wouldn’t be anything for the people when it went wrong ?

  22. @Seafóid – that each and every pension asset manager had an over-allocation to equities (including blue-chip banks) does defy my comprehension. For decades, the fund management/actuarial/pension advisory industries came up with the idea that, over the long run, equities outperform bonds. They then defined the long run as any 5 year period and, to compound the fallacy, decided to ignore relative valuations at the point of investment.

    If I were to present you with a theorem that stated X>Y therefore X>nY, would you not, correctly, call me an idiot? That theorem, unfortunately, was effectively peddled by the pension advisory industry in their slavish devotion to equities over bonds even as multiple expansion became increasingly the main source of positive equity returns into the mid-2000s. It’s not as if wake-up calls hadn’t occurred in 1987, 1998 and 2001 (let alone 1974).

  23. Aiman not sure what ur point is.

    Pensions should be invested in equities for the most part (until you start approaching retirement)

    A big problem with DB now is that they now force people to fund using bonds.

  24. It’s disgusting how a profitable company like Glanbia can plead the béal bocht and unilaterally change terms for pensioners.

    But then, the big beneficiaries of public pensions are not very concerned about such issues.

    A survey carried out by the Irish Association of Pension Funds (2003) showed that in 2002 the average employer contribution rate for defined contribution schemes was 6.7%, whereas the average for defined benefit schemes was 10.7%.

    http://www.pensions-institute.org/workingpapers/wp0821.pdf

    A total contribution (employer and employee) of 10 to 12% wouldn’t provide much of a pension.

    The Minister for Finance Brian Lenihan said in Feb 2009 that the total cost of a State pension for an Irish public sector worker, hired after 2004, was 26.1% of pay, and the employee paid on average 4.8% of the cost, before the introduction of the pension levy.

    Pre-2004 staff cost more.

    Average group managed funds annual returns over 10 years to July were 4% before inflation and fees.

    In 2010, Irish pension funds still held average equity allocations of 50% and the level was 47% in the UK according to Mercer.  Allocation to equities across the rest of Europe remains low, particularly for many funds in Germany (5%), due to local regulatory restrictions. In the Netherlands pension funds hold an average equity allocation of 26% and in Switzerland 30%.

    Both the UK and Ireland continued to have the highest equity weightings (c. 44%) in 2011.

    Enda Kenny said in 2011 that he would have fund fees investigated but NTMA possibly advised him against alienating their potential clients.

    Research shows that fund managers rarely beat broad based indices.

    Pension trustees usually rely on advice from conflicted individuals.

  25. Michael get most stuff right there – particularly that the main problem with DC is the rates contributed rather than the structure.

    I am 30 now and retiring in 35 years in a DC scheme. Can somebody give me any 35 year period in history when I would have been better invested in bonds?

    If Irish pension funds had been 100% in bonds for ever with the same contributions their funding position would now be worse!

  26. @Actuary – why in god’s name would anybody invest statically in the one asset class on a 35 year view? One can switch between asset classes as the relative valuation levels between them alter. Sometimes equities are better value than bonds, sometimes bonds are better value than equities, on five year time horizons.

    Nobody would suggest that a pension fund should be 100% in bonds forever – that would be as silly as being 80% in equities for 35 years regardless of their absolute and relative valuation levels.

  27. I strongly disagree with the idea that DC is better than DB. In the past few years, huge deficits have appeared in DB schemes, and employers have in most cases responded by increasing their contributions. In DC schemes, no deficit exists because a member’s entitlement is defined as equal to his assets. If the value of the assets plummets, then in a DB scheme this is considered a problem whereas in a DC scheme that’s just how the cookie crumbles.

    The big problem with DB schemes is the fact that pensioners have first priority on the assets. I don’t know what the funding level in the Waterford Crystal scheme was but it might have been, say, 60% funded overall. The effect of the windup rules existing at that time was to translate that overall 60% into 100% for pensioners and 25% for those not yet retired. The idea behind sovereign annuities is to give the scheme trustees the option of making that, say, 100% for pensioner but with added risk, and 80% for those not yet retired. I consider it an improvement to the windup rules, because some mechanism for sharing the pain was needed. It does leave trustees with some very difficult decisions to make, but winding up an insolvent scheme is always going to be extremely difficult.

    If we has an insurance scheme for DB pensions, whereby a certain minimum level of benefits is covered no matter how bad the deficit, then DB would be the clear winner. (In the UK, the PPF acts like this.) But unfortunately we don’t have one and now is probably not the time to set one up.

    @aiman
    The trick is knowing when to make these tactical switches. How exactly can you tell when bonds are overvalued relative to equities, or vice versa?

  28. @aiman there is no evidence that ANYBODY has been able to consistantly pick whether equities are better value than bonds or vice versa.

    Show me ANY fund manager who has been able to consistentally beat an indexed world equity fund over a long period (20 years+).

    They dont exist. Lots of people promise to do it, charge fools a small fortune and then dont do it. Study after study has shown this.

    My equity only strategy will beat your tactical asset allocation strategy every time. (and by a lot).

  29. How many ‘experts’ correctly reacted to developments in February 2007?

    Finfacts reported on February 08, 2007 on the news of the US subprime mortgage bust:

    Global bank HSBC burnt by slowing US housing market; Percentage of HSBC mortgages more than 60 days past due is climbing

    Two weeks later on February 21, 2007, the ISEQ index rose to an-all time high of 10,041 and the Financial sub-index rose to 18,098. Bank of Ireland closed at €18.65; Anglo Irish closed at €16.64 and AIB closed unchanged at €23.95.

    A year later, on February 21, 2008, AIB closed at €13.80, Anglo Irish Bank closed at €8.84, while Irish Life & Permanent closed at €10.20 and Bank of Ireland traded at €9.50.

  30. @ronankeane

    “but we don’t have one and now is not the time to set one up”

    So Is DB still better without one? (you have to laugh at the name defined benefit – the opposite of ronseal)

  31. @ Actuary

    I think the best thing is to have properly run, well funded DB schemes. Even our current, quite imperfect system, is a mechanism whereby contributions tend to increase in reaction to investment losses or other adverse conditions. If forced to choose between DC schemes with low contribution rates, or DB schemes with poor risk management and a quirky regulatory regime… I’d go with the money (i.e. DB.) But I’m acutely aware of how the DB regime can amplify the worst outcomes, so it’s not an easy call.

    The term ‘defined benefit’ is only misleading if you read ‘defined’ as ‘cast-iron guaranteed’.

  32. @Aiman so 1000’s of pension schemes mking 10’000s of asset allocation decisions and at least 1 got it right.

    You then present this as skill rather than luck.

    Okaaaaaaaaay

  33. @Actuary – you asked for one, I pointed you to one. I didn’t present it as anything – but you’ve made your mind up it was luck.

    How come most of the actuarially advised DB pension schemes in these parts have achieved such miserable investment returns following the static valuation-insensitive equities-drunk-or-sober mantra? Would it have been a good idea for a fund to be 80% equity invested in 2000/01, at the top of the tech bubble, on the grounds that, to quote yourself, they’d outperform over 20 years? Or in 2007? Are you suggesting that the equity declines that occurred were completely unpredictable – acts of God, so to speak?

    Tactical asset allocation, as practised by the fund management industry, tends to consist of shovelling money from one geographical area to another, or from one industry sector to another or, at its most feeble, shifting a percentage point or two from one asset class to another, in order to be very slightly longer or shorter than their competitor funds.

    Equity returns should of course reflect economic growth, in nominal terms, thus over the long run (ex-depressions). However, the returns from the major indices from the early 1980s on comprised a large element of multiple expansion, rather than simply reflecting growth in corporate profits. Suggesting that equities, at any multiple, will outperform bonds at any yield, over any given (say) 10-year period is bonkers. Can you point to any equity market with p/e ratios of over 20 that has, in the subsequent decade, outperformed the bonds of that country?

    If I were told I had a one-shot chance at making an investment decision, and it was both for 35 years AND irreversible, I’d pick equities myself at present. But it isn’t a one-shot irreversible decision that faces people, or those they entrust with advising them on the deployment of their funds.

  34. @aiman.

    I asked for evidence that someone could consistently pick when to switch – not do it once.

    Your views are wrong and I urge you to examine them and do some research.

    Try looking up Markowitz, Miller, Sharpe and Fama for a start.

  35. “Your views are wrong and I urge you to examine them and do some research.”

    I find the certainty and arrogance of the youthful actuary a reliable constant in this ever-changing world. Reliable, but not comforting.

  36. @aiman – you are the one who can predict the markets not me.

    I am fully aware of my own stupidity – if thats arrogance fair enough.

  37. @Actuary – the debate has gone on too long. I’ve never accused you of stupidity, no more than I have arrogated to myself the ability to predict markets. I find it depressing that your industry has such a bereft and static view of the world. I can understand that, in order to pass your exams, you had to adopt it, or fail. It doesn’t make it correct, however.

    I’ll repeat – the concept that equities at any multiple will outperform alternatives is flawed (but, due to its wholesale absorption by the investment community, it self-perpetuated for many years).

    For the actuarial industry to throw up its hands and say that markets are predictable – which is what the equity-centric advice has been for many decades – is as helpful as saying they are unpredictable – which the actuarial profession has also been saying. Whoop-de-doo.

  38. @Aiman & Actuary

    With respect, the debate on DC v DB is one for a separate thread.
    This one is Sov Ann and Amortising bonds.

    My own view on Sov Ann is that it is perfectly rational for pension fund trustees to buy them; they have admittedly had the electrodes connected to the nether regions in terms of the funding standard but that is the prerogative of the government and its agencies. Also DB schemes are in absolute crisis.

    I would say that compelling pensioners in a mature scheme to take 100% of their pension in a SA may prove a bridge too far for most trustees even under pressure from the employer to do so.

    I think Aiman and Actuary have made some very good points on the train wreck that has been pension fund investment but as I say, another thread required.

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