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The Actuary The magazine of the Institute & Faculty of Actuaries

Ban the bonds

Early in 2003, with the equity market at its lowest level for 25 years, I wrote to the presidents of the Faculty and Institute, suggesting that recommendations by actuarial consultants, regulators, and actuarial articles for fixed-interest bonds to match long-term liabilities were inappropriate. Since then long-term gilt yields have fallen further while the equity market has risen over 85%.

We all know equities carry risks; this should be remembered particularly when markets have risen substantially – but they also carry the prospect of the complementary feature, reward. Fixed-interest stocks offer hardly any chance of reward, only risks of falling prices on rising yields (and default risks with lesser-quality bonds).

Institutions are not alone in their misunderstanding of matching bonds with long-term liabilities. Indeed the regulators appear to treat life assurance companies as if they are comparable to banks who borrow short to lend long and whose accounts need to balance in money terms.

The long-term nature of life assurance and pension fund business means the managers should select the best investment opportunities available, commensurate with their prospective liabilities. Market price fluctuations affect bonuses and dividends, but rarely the underlying solvency of insurance companies provided business is transacted on profitable terms (the Equitable Life notwithstanding).

Pension funds are required to value liabilities at current low rates of interest thereby exacerbating deficiency problems; the latter is increased with ill-advised bond investment, encouraging more funds to close final salary schemes. Several pension funds are trying novel ways to reduce current deficiencies. Investment bankers – not actuaries – have been asked to recommend solutions, which is perhaps not surprising given the lack of focus by the Faculty/Institute on subjective finance, economics, and investment matters. Investment bankers may be considered to have a better knowledge of pension funding than actuaries have of corporate finance!

An institutional strike against long gilts on low yields, which is advocated by the writer, might even force the Treasury to issue better-yielding gilts and inflation-linked bonds.