(December 4, 2013) — When a company collapses, its shareholders, creditors, and suppliers crowd in over the carcass—pension funds are often at the back of the queue. In a two-part series, aiCIO looks at the lifeboats that have been created to help the defined benefit pensions stay afloat—and the risks facing the models they have employed.
Last month, Ireland’s government announced a 0.15% pension levy, which in theory could be built up into such a lifeboat. This move was partially due to the furore around the collapse of Waterford Crystal in 2009. The UK’s Pension Protection Fund (PPF) saved the manufacturer’s scheme in that country and claimed a collection of antique china to plug the fund’s deficit. However, Irish pension fund members were left with a DB plan that could cover just 28% of its liabilities.
The Irish government was cited by the European Court of Justice for a “serious breach” of its obligation as an EU member state over its failure to guarantee at least half of the DB fund’s pension promise.
Should Ireland decide to create a backstop fund, from which model should it take the most inspiration? Let’s put them in the ring together and see which lifeboat is least likely to sink.
Channelling aiCIO’s inner Michael Buffer: In the blue corner, the original lifeboat fund, all the way from the US of A, it’s the Pension Benefit Guaranty Corporation (PBGC)! And in the red corner, it’s the plucky newcomer from the UK, the PPF!
Seconds out…
Ding, Ding! Round 1: Financial position
The PBGC, set up in 1974 under the Employee Retirement Income Security Act, looks after 32 million workers and retirees in 23,000 plans from single employers, along with 10 million workers and retirees from 1,400 multi-employer plans. It manages $85 billion in assets, the vast majority of which are from the single employer plans, but is running a record level deficit of $35.7 billion.
Compare that to the UK’s PPF. Set up in 2004, the fund looks after 87,000 retirees and workers’ benefits and has around £15 billion in assets under management. Unlike the PBGC, the PPF is running a surplus—a £1.8 billion surplus to be exact.
If we turn the clock back five years, the PBGC then ran a $10 billion deficit; the PPF, a £517 million deficit.
While it’s far too simplistic to look at the current financial position as it stands today—given the differing discount rate methods, the fact the PPF has to worry about inflation indexing, and that the PBGC is 30 years older than the PPF—it is worth assessing how their investment allocations and strategies differ.
Let’s take the PPF first. At the start of December, the UK’s lifeboat fund has around 70% in cash and bonds, with the ability to increase or decrease the allocation between 65% and 80%. It also invests 10% of its assets in public equity (with a tolerance range of between 5% and 20%), and 20% of its assets in alternatives (with a tolerance range of between 10% and 25%). In the fiscal year 2012-2013, the PPF also directly invested in property for the first time, exchanging contracts to buy two investment properties for a value of £10.2 million.
In addition, the PPF board permits some tactical views to be taken to either enhance return or control risk, provided the positions operate within the overall 4% risk tolerance set by the board.
Portfolio construction to one side, the returns were also pretty good for 2013, achieving double digit growth for the second year running.
Global equities were a key part of the portfolio’s success, delivering a 16.3% average index return in the 12 months to October 2013.
Global bonds also performed well, delivering a 4.8% average index return. A further 1.4% return was also gained over these indices by actively managing the portfolio. The bond portfolio is also more diversified today, following the PPF’s decision to hire managers with competencies in absolute return strategies, asset-backed securities and emerging market debt, global sovereigns, and corporate credit in 2012.
Compare this to the PBGC. CIO John Greenberg tells aiCIO the fund has always roughly been 30% in equities and 70% in cash and bonds. In the last two years, it has diversified its geographical bases, moving from domestic equities and bonds to global securities.
The PBGC also has a small allocation to private markets—2.4% to be precise. Among these assets are equity, fixed income, and real estate funds that invest mainly in buyouts, venture capital, distressed debt, and commercial real estate.
But all of it has come into the fund from the insolvent corporates’ pension funds, none of it was sought by the PBGC investment board—although Greenberg stressed that “nothing was off the table” in terms of investing in private markets in future.
Result: PPF Win—for a far more diversified portfolio and superior returns
Continues on page two…
Continued from page one…
Ding, Ding! Round Two: Investment Strategies
The PPF has one of the most refined strategies in the UK DB market. It targets out-performance over the liability benchmark of 1.8%, and has taken the unusual step of employing two liability-driven investment (LDI) managers (Legal & General Investment Management and Insight Investment).
The fund also has a portfolio of swaps, bonds, and cash applied as an overlay, to make the assets mimic the expected liability cash-flows. The overlay also includes derivatives designed to hedge out interest rate and inflation risk.
And if that wasn’t sophisticated enough, there is also currency overlay, which accounts for 2.5% of the portfolio and provides a source of pure alpha. Derivatives are also used to hedge currency risk in all other asset classes.
There are also plans afoot to move away from seeing assets as either growth assets or liability matching, and instead install a framework which recognises that some assets could perform both roles.
By comparison, the PBGC has no formal LDI framework, although Greenberg is keen to stress that all decisions are taken with the fund’s liabilities at the forefront of the board’s mind. And while there are some derivatives within the portfolio, there is no overall overlay for hedging currency, interest rates, or anything else.
It has embarked on a path of greater diversification since the onset of the financial crisis, but Greenberg insists the measures were being put in place way before 2008. “With diversification, a lot of it took place in 2008. And a lot of it was in the works prior to the crash. It was about diversifying the portfolio, rather than reacting to the crash. We’re long-term investors so we’re not going to change our strategy with each market move,” he says.
Greenberg asserts the PBGC came out of 2008 “pretty well”, partly due to its large allocation to US treasuries. A quick look at the annual report for 2009 shows the deficit almost doubled between 2008 and 2009 from $11.2 billion to $20.1 billion, driven in part by the high number of new entrants into the lifeboat fund. Even an investment portfolio return of 13.2% for the financial year of 2009 wasn’t enough.
By comparison, the PPF—at this point five years old—was in the process of turning 2008’s £1.2 billion deficit into a £400 million surplus, a feat achieved by March 31, 2010. Its returns were also higher at 15.2%.
There were criticisms in the US media that the PBGC had invested heavily in equities in the run up to 2008, but Greenberg says this is untrue—the PBGC was simply buying some equities as part of a normal rebalancing exercise.
That year’s annual report shows that equity securities represented 37% of the fund’s total assets at the end of 2009, up significantly from the 27% invested in equity securities in 2008.
There are those who feel the PBGC today has reverted too far the other way, limiting their equity exposure to around 30%. Critics of the lifeboat fund say the $35 billion deficit it is suffering from today would not be as large if the PBGC had invested more in equities, particularly given their performance over the past 18 months.
Ron Gebhardtsbauer, the PBGC’s former chief actuary between 1986 and 1994, wrote in June 2010 that the PBGC should be considering investing more in equities than it was (by 2010, the PBGC’s equity allocation made up 31% of the portfolio). Gebhardstbauer claims that had the PBGC followed its then former director’s recommendations to move to 40% in equities in 2009, it would have had $10 billion more in assets, or to put it another way, its 2010 deficit of $23 billion would have been almost halved.
Others believe the fund has done the right thing in limiting equity exposure. Ari Jacobs, senior partner at Aon Hewitt, says most of the previous administrations believed they should try to limit exposure to the broad equity markets because the size of their underfunding is negatively correlated with the equity markets.
“If the equity markets go down, it’s more likely that companies will go into bankruptcy which will increase the stress,” he adds. “The PBGC doesn’t want to be losing funding at the same time as it has to take on more pension funds. It had a good rationale for why it wanted to be invested in securities which were counter cyclical.”
As part of Greenberg’s refocussing on risk management, the PBGC has in the past year “put a lot of money and effort” into its risk practices, including buying and installing the BlackRock Aladdin system.
Aladdin provides a centralized database for maintaining financial information including positions, transactions, prices, security data, and analytics. “We installed that so we could have a better read on what our risks were, both asset only and asset liabilities,” says Greenberg.
“It does a really good job talking about what the exposures are. Let’s say there’s 15 different names for Coca Cola bonds, with a push of a button we can find our total exposure to Coca Cola across all of the asset classes.”
Greenberg rebuffs any suggestion that the investment strategy is the dominant cause of his sizeable deficit.
“As interest rates declined, our discount rates declined, and that’s really driven a lot of the deficit. We have a unique way of setting our discount rate and it’s really affected by interest rates. What’s happened since 2007 is that they’ve dropped and that’s one of the primary reasons the deficit has grown,” he insists.
His deputy Dave Mudd adds that interest rate issues are only part of the problem: the PBGC’s deficit has also been affected by the rising number of plans entering the lifeboat since 2008, and the fact that—unlike the PPF—it has no power over its premiums.
“Raising premiums alone wouldn’t erase the deficit. It’s our inability to set the premiums, the interest rate situation, and it would be good if plans didn’t fail. It’s all of these things,” he adds.
Result: A draw—PPF picks up points for sophistication, while the PBGC lands punches for gamely persevering despite the body blows of falling interest rates on its liabilities.
Check back tomorrow to see the final rounds in this heavyweight bout…