Over the past 2 years, a revolution has been quietly brewing. Rather than using portable alpha or liability-driven investing some pension plans are throwing in the towel entirely and off-loading their funds to third parties. One such third party is the innocuously-named Pension Corporation, a London-based company whose business includes buying up pension liabilities. Today as part of our series featuring members of the CAIA Association, Dr. Bob Swarup, CAIA, a Partner with that firm explains what led to the birth of this potentially massive new industry. Bob holds two Master’s degrees and a Ph.D., is active in the CAIA Association and has written various articles for FT Publications, the Daily Telegraph and New Scientist.
Alternative Viewpoints – “Pension Buyouts”
Special to AllAboutAlpha.com by: Dr. Bob Swarup, CAIA, Partner, Pension Corporation
To much of the investment community, most pension funds are boring entities eternally bound to old family recipes of formulaic asset allocations – Balanced, Conservative and Growth – all left to ferment for the next half century or so. The logic is impeccable – they have the luxury of a long-term perspective, many adherents will argue, that allows them to ignore the short-term volatility of the financial markets and focus on harvesting the inevitable risk premia of these asset classes over time to meet the liabilities of their pensioners as they fall due.
Ironically, this same attitude is also responsible for making pension funds the perennial cold call for every manager looking to add some ‘sticky’ money to their assets. They are comfortable with modest (others may term “disappointing”) returns, they are slow to redeem (unlike the rest of those pesky investors) and they are remarkably understanding of failure, just like your mother was after you drove over the family cat.
But there is a small problem in the background of the picture. Most pension schemes are chronically in deficit and the problem is only set to worsen in the current economic climate. Everyone has talked ad infinitum about the $700bn bailout package in front of Congress to stem the hemorrhaging from the credit crunch. I doubt if many realise that a similar amount is also needed, for example, in the UK to fill the deficit in just that country’s private sector pension schemes. Throw in the public sector and you’re talking up to another $2 trillion.
The problem is particularly acute for defined benefit schemes – occupational schemes where the pension benefits are fixed in advance and are often calculated as a proportion of an employee’s final salary. Many often include provision for dependents such as widows and can even be indexed to inflation. These proved to be enormously popular in the aftermath of the Second World War, where many companies saw them as an effective way of deferring compensation for many workers to future years. However, these schemes placed a host of unintended and poorly understood risks with the sponsoring employer, such as exposure to longevity, future interest rates and the capricious whims of financial markets.
Any views on interest rates over the next decade? The company’s debt financing may have excellent terms and it may seem a moot point, but the pension fund’s liabilities and associated accounting costs will swing violently over the next few decades with the prevailing interest rates. By some estimates, the drop in long-term interest rates from 1999 to 2002 increased the value of pension liabilities by 30-40%.
How about inflation? Scheme members may have index-linked pensions and the burden of payments can quickly become onerous. Figures from the UK Office of National Statistics show that from 1970 to 2007, annual employer contributions into pension schemes went up 53 times, and trebled over the last seven years alone.
And what about people living longer? For individuals and society, increased longevity is desirable, but living longer can often also create large unanticipated costs. Ever since the German Chancellor Otto von Bismarck thought he’d pulled off a politically brilliant move back in 1889 by promising pensions at 70 when the average German lived to less than 50 years, the continual improvements in life expectancies have rapidly unravelled the best laid pension plans. Even more troubling, the current upwards trend shows little sign of levelling off.
It’s a growing headache for many firms, for whom such risks often lie far from familiar territory and who are charged with looking after a broad church of stakeholders, not just pensioners. Though the increased pension fund liabilities are often longer-term than most corporate horizons, they must be carried on the company’s balance sheet, reducing net asset value and increasing financial leverage. As the corporate sponsor, they generally also have an obligation to fund at least part of these unexpected costs, giving them an uncertain command over their own cash-flow and reducing future distributions to investors as well as impacting the share price.
In the case of General Motors, for example, net obligations are estimated to be about $170 billion across all of GM’s US operations, dwarfing its current market cap of about $5 billion. To meet its soaring obligations, the company contributed an astonishing $30 billion to its US pension plans in 2003 and 2004 but the accounts are still tens of billions of dollars in deficit. Now, pension and healthcare costs make up more of the average GM vehicle’s price tag than the steel used to build it. The result is that the company is inexorably losing ground to a wave of foreign competitors with lower cost bases and less debt on their balance sheets. The result has been a catastrophic decline for investors in stock price from $55 in January 2004 to under $10 today.
These are numbers of little concern to most of the readers on this website. Instead, GDP, the market indices, and FX rates are all far more pressing and important to their day to day jobs. If it all goes well, having a decent pension at the end of the day is the least of the rewards.
So why care? Because problems demand solutions and where solutions can be found, investors are usually not far behind. Like any other risk, these uncertainties – interest rates, inflation and longevity – can be managed and even reduced once understood.
It’s a market opportunity that astute investors have not missed. A whole industry is springing up in the UK offering so-called pension buy-outs, where the pension liabilities are transferred away to dedicated specialists. In return, these dedicated specialists acquire assets up to the value of the liabilities and seek to manage the whole lot holistically and efficiently.
It’s a win-win situation for everyone. Buyouts can often improve the situation for pension scheme members as these specialist companies are tightly regulated, operate within strict investment and asset-liability guidelines, and have to hold capital against any extreme losses. It also helps troubled sponsors: securing pension liabilities away from balance sheets improves their ability to raise finance. Above all, it enables management to get on with running the business, free from the peripheral distractions of administering a pension scheme.
Since the niche began about 2 years ago, it has taken off in a big way, with the entrants including blue chip financial companies, hedge funds and private equity firms. Some participate directly but most have gone through other vehicles as one of a consortium of backers.
Pension Corporation, for example, raised close to $1.7bn in 2006 from investors including JC Flowers, Swiss Re, Och-Ziff, HBoS, RBS and UBP Private Equity. That should allow the firm to buyout around $16bn of liabilities.
It may seem a large number but it is a drop in the bucket compared to the potential size of the market. To give you an idea of the scale, the private sector in the UK has some $1.6 trillion of pension liabilities and there are an additional $2 trillion of public sector liabilities on top. So far, all the deals done in the marketplace make up perhaps a mere $20 billion – a fraction of the one-third of trustees that want to buyout within the next decade.
It’s a rapidly growing business and is leading to wide-ranging changes in the way pension funds manage their assets and liabilities. The new mantra is asset-liability management, new strategies for hedging interest rates and inflation, innovative ways of mitigating longevity risk, portfolios run on an absolute return basis and the demand for superior risk-adjusted returns from managers.
In short, pensions are catching up with the rest of the investment community. But that’s a post for another time.
– Bob Swarup, October 3, 2008
The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.