“In Fridays Audio Eoin mentioned the effect of the bond bubble bursting on the value of pension schemes.

“On October 5th Investors Chronicle contained an article about the pension liabilities of FTSE 100's defined benefits pension schemes which I will attempt to scan and send it to you.

The article contained the top and tail of a table produced byJLT Capital Strategies showing those

“FTSE companies with funds in surplus or in deficit. My initial reaction was to give this more emphasis when considering due diligence. After all, despite reservations relating to the manner in which these liabilities are caculated, they are in addition to whatever gearing a company may have and reflects its governance. The risk may also be of regulatory changes and tighter solvency conditions imposed inappropriately by inexpert experts which may lead to deficits being crystalised. I notice that one or more of the companies may have appeared in lists of dividend aristocrats/autonomies.

“As I understand it, pension fund managers tend to buy bonds to cover their known liabilities, so am I right in thinking that where the purchases are specifically for pensions and annuities already being paid the current value of the bond is to a certain extent irrelevent if held to maturity. If, as a result of bonds falling and the consequent reduction in value of a pension fund, would the liabilities of the pension fund necessarily decrease to the same degree? Presumably if bond yields increased the value of bonds needed to meet future liabilities would fall?

“ Would the main concern be the huge total value of bonds held within pension funds, said to be in excess of 50%, the highest level for some decades. However nimble pension fund managers may be, the sheer volume of bonds would surely preclude them from reacting quickly.

"I did try to get the whole of JLT's table but failed.

“ On rereading this I do wonder whether my thought processes are a little naive, if so I apologise. Despite benefitting from your valuable daily audios and reports one never stops learning.”

Eoin Treacy's view Thank you for this email which raises some important issues. If anyone has more information on the regulatory implications of pension deficits in defined benefit schemes we would be happy to hear from you.

There seems to be a wide disparity between the ideals of pension fund management and reality. In some cases pensions were based on the assumption that an ever increasing workforce would ensure that new entrants helped to pay the pensions of older workers. As this has failed to materialise and as returns have failed to keep pace with expectations, pension funds have developed significant deficits. Many companies have closed defined benefit programs to new entrants and are struggling to deal with the obligations the existing programs represent.

The yield to maturity argument for bond bulls is credible in a disinflationary environment because one can purchase a bond, hold it to maturity and the return will have held its value. However, in an environment where inflation outpaces that yield, such as has been evident in the UK for the last few years the situation is very different. The return on a bond yielding 1.5% when inflation is at 3% loses 1.5% compounded annually in real terms. Therefore the ability of a pension to meet future obligations is constantly eroded. Since most pensions assume an annual rate of return of 8% in order to break even, one can understand why so many are underwater.

Since pensions have gotten themselves into such a mess during one of the greatest bond bull markets in history, one can only imagine how they are likely to perform in a bear market.