Tremors of new pensions shock

To adapt an old saying, there are lies, damned lies and calculations of pension deficits; without wishing to question the basis of Watson Wyatt's calculation, the result is dangerously
misleading. Any finance director or pension trustee who thinks the worst is over could be in for a nasty shock.

The reason is explained by some work from Redington Partners, a consultancy that employs advanced financial engineering techniques to control pension-fund risk. The firm points out that things have, in fact, been going badly for
pension funds in recent months because around the world both share and property prices have been falling.

At the same time, the cuts in interest rates by the Bank of England would typically have been expected to add to deficits. But this has been offset by a surge in spreads, so that the rate set by the Bank has not resulted in lower rates throughout the system. Markets have instead taken the opportunity to reprice risk.

This means that the return on the double-A bonds, used for calculating the discount rate, has increased sharply. So the negative of falling asset prices has been offset by a reduction in liabilities caused by higher interest rates.

It is because of this that the funds are
in surplus, which seems like good news until you think in detail about what it really means. On the one hand, we are saying that pension funds are in good shape and doing no damage to the balance-sheets of their sponsoring companies. On the other, the market is telling us — with the price it sets on AA bonds — that the outlook for corporate financial health is bleak.

The British end of the body that sets accounting standards flagged recently that it does not believe double-A bonds are the correct measure for calculating discount rates. It suggested moving to a more robust measure closer to the
risk-free rate of return.

This could be a gilt, or possibly something like the Libor swap rate. If these were already in place there would have been no offset from widening spreads, and the widening deficit position of funds would be obvious rather than
the comforting feeling of surplus.

There is also a separate but similarly unrecognised problem. For some years, the predicted inflation rate derived from the swaps market has been 3%.

When the credit crunch began this rose to 3.35%. Then in March it spiked again to 3.8%, and the debate in the markets is about whether it will shortly go to 4%.

The point here is that an increase in the predicted inflation rate means that the long-term real rate of return which a pension fund can expect to achieve on bonds is also lower — in this case significantly lower. Indeed, real rates of return are now back at the depths they plumbed three years ago, when 50-year bonds were being sold at real rates of under 1%. Again this shift is not widely reflected in the current debates about funding levels .

Thus the ground is being prepared for another pension shock. One can only imagine the psychological impact this will have on plan sponsors and trustees, who were just beginning to think it was safe to go out at night.

Carbon trading's climate of success

In the world of stock exchanges, the past few months have been marked by a tumbling of the share prices of the exchanges themselves. The London Stock Exchange has been singled out for
mention as investors digest the possible impact of increased competition from new electronic trading platforms.

But in truth, all exchanges have retreated from the heady valuations of last year. There is, however, one notable exception — one group whose shares have risen an astonishing 80% in the first three months of this year. It is the AIM-traded Climate Exchange Plc, the parent company of the European Climate Exchange in London and Chicago
Climate Exchange in the US.

The share price is probably getting a bit ahead of itself, but the cause of the excitement is clear enough. As the EU ushers in the second phase of its " cap and trade" approach to curbing emissions, the volume of trading is moving
sharply upwards. In addition, ECX has just introduced a futures contract based on UN-issued credits for carbon-saving projects in emerging markets, which is arguably the first key step towards creating a benchmark world price for carbon.

There is still a long way to go, of course, but one can see why people see this as the market of the future.