In the aftermath of the credit crunch pension investment professionals being questioned by a pension fund trustee may have felt like Dustin Hoffman strapped to Laurence Olivier’s dentist’s chair in the film Marathon Man being asked the same question over and over again: is it safe?  The wrong answer may lead to the acute pain of losing a client. Given the havoc wreaked by ”innovations” in structured credit it is unsurprising that boring traditional approaches are embraced as conservative and safe. The selection of benchmarks in the credit area is one of those traditional and ostensibly unremarkable practices which have thus far escaped critical scrutiny. But tradition in this case spells danger for trustees.

Investment consultants have typically advised pension funds selecting corporate credit managers to benchmark their performance against a long-term sterling bond index comprising AA rated bonds such as the IBoxx over 15 year AA index. Ostensibly this is appealing: this measure not only embodies the level of credit quality for non-sovereign risk with which pension funds are instinctively most comfortable, but is also the discount rate used by most employer sponsors of defined benefit schemes to value their pension liabilities for their financial statements. Those preaching the gospel of LDI emphasize the importance of pension funds setting targets for growth in their investment portfolio relative to increases over time in the absolute value of their liabilities; if the liabilities increase at the long-term AA rate then this sounds like a plausible performance benchmark.   

This conventional approach, however, suffers from both theoretical and practical deficiencies and creates hidden risks. From a portfolio standpoint measuring the current value of pension liabilities using a AA bond rate is increasingly recognized as inappropriate. The leap in credit spreads at the onset of the credit crunch had the flattering effect of reducing pension liabilities for any given yield curve and the Chairman of the Pensions Regulator, David Norgrove, has criticized this accounting convention as “bizarre”. Given the volatility in AA credit spreads shown this is unsurprising. 

The Accounting Standards Board proposed moving to a risk-free discount rate to value pension liabilities and the Pensions Regulator has highlighted the shortcomings of FRS17 valuations for trustees assessing technical provisions (i.e. liabilities). Where there is a functioning swap market the way to measure the economic value of liabilities is to discount each expected fixed or index-linked future cash flow at the relevant nominal or real zero coupon swap rate. The AA bond rate is the wrong target to beat.

The fact that a long-term AA bond yield target has been used as a benchmark in the corporate credit space also seems to be related to the idea of constructing a duration matched portfolio where movements in prices of fixed income assets will be equal and opposite to changes in the value of liabilities. However, the asset management mandates for investment grade corporate credit awarded to active fund managers relate by definition to dynamic management and have portfolio durations (5-7 years) that are unrelated the much longer duration of scheme liabilities. Within each asset class managers should focus on maximizing absolute returns within the risk constraints mandated by the pension fund client. We would recommend comparing ex-post manager performance to changes in value for a static control portfolio, or relative to a fixed margin over cash or swaps for the target duration of the credit portfolio.

In practice using a traditional benchmark index yield tends to lead to underperformance and at times of market stress, severe underperformance. The benchmark index naturally reflects the universe of issuers of the credit quality and tenor captured by the index and is therefore heavily influenced by market trends. There was huge growth in subordinated debt issuance by financial institutions 2005-7 as banks sought to boost their regulatory capital positions without issuing more costly ordinary equity. The share of financial issuers in the index doubled to nearly 40%. Where credit fund managers are measured relative to an issuance-influenced benchmark the natural inclination of the manager is to hug the index by investing a significant proportion of the portfolio in a basket which will have a beta of close to 1 relative to the benchmark, leaving high conviction trades as a minority of assets invested. Thus when markets overheat the average manager’s portfolio will reflect all the distortions and biases of the era. When the credit crunch arrived and bank stocks and debt prices plunged, the portfolios of long only corporate credit funds partly tracking the index suffered commensurately. If a credit fund manager had been given a return target related to cash plus a margin combined with volatility and concentration limits, a portfolio could never have become as distorted as the index. 

In today’s Financial Times, Chris Redmond of Towers Watson comments pertinently about the appropriateness of a bond benchmark: “Is the benchmark useful from the perspective of investing? A key issue that became acutely apparent through the global financial crisis for some clients was what actually comprised their fixed income benchmarks.” The unfortunate history of subordinated financials has not been an isolated case.  As Edmond mentions with respect to the credit crunch, “some clients were surprised by the extent to which asset-backed securities represented a significant component of their benchmarks, and the associated impact on performance as this asset class experienced extreme turmoil”. A masterly piece of understatement. The momentum problem will certainly emerge in another form in future. Michael Lewis’ next new, new thing will in all likelihood involve a cycle of excitement and disappointment about some debt-driven sector of the economy that will attract capital on increasingly favourable terms; issuance momentum will affect the composition of traditional benchmark indices, dragging benchmark-huggers behind it. (The same argument applies to using capitalization-weighted stock market index benchmarks).  Traditional benchmarks make managers lazy and get them shadowing an index which in the case of credit is not even relevant for the accurate measurement of a fund’s liabilities. It is a pity that pension consultants have developed a blind spot regarding the appropriateness of the long-term IBoxx index as a benchmark for fixed income investing by pension funds. The index may be gloriously independent with clear rules of construction; it is just not appropriate for the job.

Long only absolute return-oriented credit funds are not dumbed-down hedge funds but the best way to optimize risk-adjusted returns for a given portfolio allocation to corporate credit. The “safe and conservative” approach to establishing benchmarks exposes the fund client to significant unnecessary risk. It is time for funds to dare to be different.   

As children we all enjoyed laughing at CoCo the Clown as the hapless fellow fell over after tripping over his own outsized feet. Despite the decline of the traditional circus as a form of family entertainment, within the financial world CoCo has reinvented himself and is making a comeback. CoCo is the new Contingent Convertible security, a type of bond that will be issued by Lloyds as this troubled bank seeks to shore up its capital base. These securities operate as normal subordinated debt instruments with a coupon that must be paid unless and until the security is mandatorily converted into ordinary shares, an event which will occur only if the issuer’s capital falls below a specified threshold. The trigger level will be set fairly low so that the option is relatively out-of-the-money and does not result in the issuer’s cost of funds being too expensive. But at least when the bank is in trouble its capital ratio will get a boost through the mandatory debt/equity swap.

Should the market for CoCos take off then the future of existing bank hybrid capital securities may be in doubt. Under the terms of many such hybrids coupons can be skipped and maturities extended, although investors buying the bonds at issue calculated that coupons would always be paid and securities would be called at the first available opportunity. After shocks such as coupon suspension by Bradford & Bingley and Deutsche not exercising its call right, EU Regulators are  now encouraging stressed bank groups to take advantage of the terms of existing hybrids to save cash and avoid refinancing and confound the initial expectations of investors; such payment suspensions and non-exercise of call rights are now obligations on RBS up to 2012 .

Surely CoCos will be positive for the stability of the world’s financial institutions?  Sadly, the benefit is unlikely to be as great as has been advertised.

One of the biggest sources of demand for the hybrid securities has been insurance companies. If a bank owns a hybrid capital security in another bank, it suffers a reduction in its capital base equal to the value of its purchase. However, insurers suffer no such adverse regulatory consequences for buying bank’s hybrid securities. So when the next banking crisis arrives (a 5 standard deviation event not scheduled for several thousand years but doubtless arriving in the next decade or two) perhaps the banks will survive without massive dollops of public money, but what will happen to the insurers? Could the insurance industry afford to see all its hybrid securities transformed overnight into near worthless equities? I rather doubt it. The next act in the opera would be insurers frantically trying to stabilize their balance sheets and capital ratios in a firesale dash for cash just as correlations jump and all markets crash as they did in the aftermath of Lehman’s demise. So instead of rescuing the banking system, the government may well end up having to rescue undercapitalized insurers. 

Which regulatory clown thought the security of the world’s financial system would be enhanced through recapitalizing one set of important institutions (Banks) by getting another set (Insurers) to buy securities whose pay-off profile at conversion makes a sub-prime Ninja mortgage look appealing by comparison?

What are the implications for members of pension schemes if CoCo’s circus spreads like wildfire? Distinctly unfunny. Pension funds buy corporate securities and often follow benchmarks which mimic the composition of a long-term bond index. If a spate of CoCos swells the relative proportion of financial hybrid securities, then pension funds will end up as passive buyers of securities with massive tail risk. And when the fanciful contingency becomes reality, pension scheme funding levels will be suffer, although the impact will be diluted by the fact that such securities are a relatively small portion of total portfolios.

If nobody is laughing when CoCo the Clown unintentionally blows himself up, why should pension funds who profess to be focused on risk management wish to become long-term holders of securities with such embedded tail risks?    

HIGHWAY TO HELL

RICHARD TRAY writes on PENSIONS:

Imagine a psychiatrist probing the mind of a corporate CEO in order to unlock the secrets of his clinical depression. The learned doctor tells the recumbent CEO to relax and plays a word association game where the CEO calls out the first word that springs to mind in response to the word uttered by the psychiatrist. After a few warm-up words to relax the CEO (for example, “Criminals” eliciting the standard response of “Bankers”) the physician gets serious.

“Death” cries the doctor; “Pensions” replies CEO instantly with an involuntary expression of anguish on his face.

A revealing answer; Sigmund the Shrink knows instantly that the CEO’s firm has a large underfunded defined benefit pension scheme and that the growth in the deficit is threatening the value of his share options. This is a deep-rooted trauma which Sigmund traces back to an Act of Parliament which converted our CEO’s good faith aspiration to provide attractive pensions into an unbreakable promise to members of the scheme (whereas the Dutch cleverly allow a significant proportion of benefit promises to be contingent on investment returns) . For such CEOs the future is often very grim indeed.

Reducing these deferred pay promises is not an option and the trends in the PPF’s charts make for gloomy reading. The PPF reports that 7400 schemes reporting to it had an aggregate s179 deficit of a mere £149 billion at the end of September 2009 which compared to around £20bn in December 2003. These figures understate the magnitude of the problem given that s179 benefits include haircuts for deferred and wealthy pensioners and use flattering mortality and discounting assumptions; the figures also include those schemes which are actually in surplus to the tune of £26bn.

With yawning deficits in defined benefit schemes, firms now face the ultimate parental nightmare – getting fined by the Government (via increased contributions and PPF levies) for the failings of their uncontrollable teenage offspring, the trustees running the pension fund. 

 Lyrics from AC/DC's “Highway to Hell”:

“I'm on the highway to hell. No stop signs, speed limit, Nobody's gonna slow me down. Like a wheel, gonna spin it”

Actually the stroppy teenage trustees are more like Angus Young of rock group AC/DC belting out “Highway to Hell” in short schoolboy trousers whilst being well over 50. But you cannot call Nanny 911 to get these lax parents to discipline their children. That is strictly prohibited. The law prescribes that the firms are responsible for plugging scheme deficits whenever they arise but do not have the power to control investment or liability management policy.

Sure, the employer can nominate some of the Trustees but they all have a statutory obligation to vacuum their brains and act wholly in the interests of the scheme members. Mindful of the impossibility of achieving perfect schizophrenia and avoiding this conflict of interest, the Pensions Regulator has erred on the side of caution by recommending that the employer’s Finance Director not be appointed as a Trustee.

Whilst recently watching a repeat of an old Two Ronnies show I was struck by the sketch involving a discussion between two west coast yokels who would not trouble the scorers on Mastermind, putting the world to rights in a pub. One asked the other what he would do to improve the human body if he were God.  The answers were predictably asinine and hilarious including the suggestion of removing the head. It appears to me that politicians and Sir Humprhries with similar frailties played the role of God having first removed their collective head in designing our current system of stewardship for defined benefit schemes - with predictably dire consequences. The liabilities of the relevant private sector schemes exceed £1trillion alone.  I know – you can hear them saying over their fifth pints -  let’s get a bunch of amateurs to look after everyone’s savings. No need for any relevant professional or financial qualifications. Let’s throw in a minimum number of employee-elected representatives but tell them they are not supposed to think as current or former employees. By all means have a small number of professional Trustees but have them only work for a few days work a year for modest pay and definitely don’t pay the others. Honest, upstanding, independent trustees – yes, we can rely on Trustees to do their duty because, chaps, they are Gentlemen. 

In unthinkingly applying Trust law to pensions governance the politicians have created another monument to the British cult of the amateur. We may have got rid of the Gentleman/Player distinction in Tennis and Cricket but it lives on in pensions. Also let’s not spend too much time on investment matters. According to Guy Fraser-Sampson NAPF data revealed that the average UK pension trustee spent four hours a year discussing investment matters. This imperial state of undress has been noted by a few other naughty children such as David Johnson (see http://tinyurl.com/ygcjqh9) and the Pensions Regulator is known to be particularly concerned about standards of governance and expertise at smaller and medium-sized schemes.

 So we are lost on the road to full pension funding and if we ask the way to nirvana, we deserve to hear the time-honoured reply of “well, I wouldn’t start from here”. Do not blame the Trustees; these poorly-armed brave volunteers do their best to cope with the ever-increasing list of responsibilities and bewildering legislative and regulatory changes heaped upon them in an increasingly complex and turbulent financial world. The edifice of pensions governance in the United Kingdom is infused with a noble spirit, but one at odds with the modern world. It’s the magnificent charge of the Trustee Light Brigade. We reap what we have sown. As we charge down the the highway to hell one cannot help noticing that it has been paved with good intentions.