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“Pascal” is the name given to a single unit of pressure. It is roughly equivalent to the force exerted by a dollar bill resting on a table. Yet, for corporations now, a prime source of pressure is the lack of dollars—or euros or pounds—weighing down their defined benefit (DB) pension portfolios.
This pressure has been building for more than five years. Although the collapse of Lehman Brothers provided a sucker-punch to every financial market participant, corporate pension funds had been feeling—and dealing with—it for some time.
By 2008, there had already been a significant shift in defined benefit asset allocation toward a more diversified portfolio. Figures from Towers Watson for 1995 to 2012 show a roller-coaster ride for equity allocations, which eventually came to a stop at 47%—some 2% down from their starting point. Bonds were affected the most by the changing mindset, however, as pensions realized “safe-as-houses” government bonds would fail to yield the required return rate. Funds in the top seven countries for defined benefit assets under management reduced bond allocations from 40% in 1995 to 33% by 2012. This switch benefitted alternatives managers, as allocations to this sector increased by 14%—a trend that accelerated after 2002 and ended up at 19% in total.
Further evidence: In 2007, there were 27 providers of liability-driven investment (LDI) products in the UK, according to KPMG, showing that pensions—or, at the very least, their advisers—had started to think about taking risk “off the table.”
Corporations the world over were already beginning to close DB funds to new employees—then, to further accrual—and looking at ways to get the remaining risk off their balance sheets.
One such fund was TRW Automotive, based near Detroit but headquartered in the UK.
“There was a variance to how each company looked at the crisis and how it would affect them,” says Peter Rapin, vice president for treasury and tax at the company. “Some were already looking at moving away from alpha investing and toward LDI. Our LDI program was already underway as the crisis started. We were making initial steps; it seemed to be the fairly obvious route for us.”
TRW’s scheme was well-funded but large relative to the size of company. Should its funding level deteriorate, TRW would be in a tight position.
This shift in attitude occurred in the mid-2000s, according to Kevin Turner, managing director in consulting in the US at Russell Investments.
“Going back to the 1990s, most plans had 60% to 70% in equities and a boring bond allocation with few alternatives,” Turner says. “After the tech crash, corporate sponsors whose plans might have been well-funded before realized this was no longer the case—and they wanted to do something about it.”
It was not uncommon for corporate sponsors of pension funds to take contribution holidays lasting more than 10 years, he says. Even in 2007, oil giant Shell said it was taking an 18-month break from paying into its UK pension fund. At the time, a spokeswoman for the fund gave this reasoning: “The fund remains in a very strong position and is heavily in surplus.”
In January 2012, aiCIO revealed that the fund would be closing to new entrants and the company was setting up a defined contribution (DC) scheme for incoming employees. It marked an end to open DB schemes on the FTSE 100.
But let’s dial back again to before the latest financial crisis.
Turner notes that, after the dot.com crash, many sponsoring companies were determined not to lose their 100% funded status again—but somehow ended up doing it anyway.
“Equities went up again, and they could still use smoothing of assets and liabilities, so they trundled on with high equities allocations,” says Turner. “Real change in the US happened in 2006—the Pension Protection Act [PPA] took away smoothing and made corporate pensions mark to market. If you had a deficit, you had to find a way of funding it quickly. It was at that point that a lot of folks started conducting thorough asset-liability surveys.
“They also realized they couldn’t rely on the passing of time to improve their funding levels,” Turner adds. “As a result, many US plans were better prepared than they might have been.”
Across the pond, in Europe, a similar movement was afoot. “We went into the 2001/2 crisis unprepared. No one had looked at liabilities, let alone duration,” says Andrew Clare, professor of asset management at Cass Business School. “By 2008, we were better prepared—some investors had diversified away from just holding domestic equities and held global equity portfolios.”
After taking shape in 1998, the move out of domestic equities toward global markets started to speed up in 2001, according to Towers Watson’s figures. The average home-country bias in the seven largest pension markets fell from 64.8% of a fund’s equity portfolio in 1998 to just 46.5% in 2012. Some moved farther away from it than others: Canada had around 36% in domestic equities, down from around 66%, whereas the US dropped its home portfolio from around 85% to 63%.
Fixed income home-bias remained fairly constant, with an average of 88.2% in 1998, and falling only as far as 82.5% in 2012. “The fixed income in their portfolios was able to hedge interest-rate and inflation risk, but there were still many lessons we were about to learn,” Clare says.
For corporate sponsors of pensions, the wheels had begun to turn, but were they turning quickly enough?
"Certain movements were already in motion—such as investors having a greater awareness of risk, but awareness and action are not the same,” says Ralph Frank, CEO of Charlton Frank, an institutional solutions provider.
For example, the LDI market, with its abundance of providers—in the UK, at least—was not finding the favor many had hoped for, according to Simeon Willis, principal consultant in the pension investment advisory team at KPMG. “In 2007,” he says, “people thought that gilts were at historic lows and equities were doing well, so why would they hedge at these levels? ‘A few more years and we will be sorted,’ they thought.”
The number of LDI products had grown in the two or three years before the crisis, Willis notes, but pension funds were still getting a grasp of what it all meant. “They thought they had to manage risk, but LDI was not attractively priced, so most didn’t take it up at that point.”
The other major de-risking option, transferring risk to a third-party insurer, had been gathering momentum, which may have indicated a coming sea change in corporate pensions approaches. In March 2006, there were two players in the buyout/bulk annuity market in the UK and US: Legal & General and Prudential. By the end of that year, the UK had seven such firms offering their services to pension funds, with another four appearing in 2007.
“New entrants to the buyout market made pricing competitive and by giving more options,” says Willis. “But 2008 was an anomaly.”
The year Lehman Brothers collapsed saw a record number of pension assets and liabilities shifted to third-party insurers. In its review of the year, consulting and actuarial firm LCP said: “Driven by competitive pricing, the half-year ending March 31, 2008, saw £4.1 billion of business written, up sevenfold from the £600 million written in the half-year ended September 30, 2007.”
That year has yet to be beaten for transaction value.
Relative to the size of its pension fund assets, the development of the buyout market in the US trailed its UK counterpart until after the crisis, when two major deals exploded onto the scene.
It seems that, in 2008, pension funds had already been getting comfortable with managing their risk through diversification and other tools, so they should have come out the other side unscathed—right?
“There were phenomena we’d not considered before: liquidity, for example. We realized that only cash was truly liquid,” says Cass Business School’s Clare. “Counterparty risk suddenly became of prime importance. Swaps had been put on, and some were even collateralized and monitored on a daily basis, but many had to be undone when Lehman fell, which took time, effort, and money—more than most people imagined. Diversification—it works most of the time, but when there is a shock, unless you’re holding your assets on Mars, there’s no escape.”
The “diversification fallacy” was one of the hardest—and most costly—lessons learned in the financial collapse. “The crisis provided a perfect storm, and it was devastating for many pensions’ funding ratios,” says Russell Investment’s Turner. “Equities and interest rates both went down, but there was value in bonds—an advantage from the PPA was that corporations measured liabilities against high-grade credit, and, given the wide spreads, this helped deficits. Those who locked in LDI at those levels had foresight, but it was a very opportunistic move.”
Of course, there were plenty who didn’t—and who still feel the consequences.
“I think everyone was caught out,” says Mats Langensjö, who chaired the Swedish government-backed enquiry into its own state “buffer” pension system. “Sweden was more stable than most, but most people didn’t have the risk systems in place or the tools to respond. It took several years until we had the guts to actively tackle the future—and then we had to ask ‘What’s our new model?’”
Sweden had suffered its own financial crisis in 1992, and there were still people in the system who remembered what happened, says Langensjö. And while he admits that the 2008 meltdown was quite different from anything seen before, known crisis management techniques proved useful there.
Elsewhere, the magnitude, reach, and duration of the crisis was unforeseeable, and, for corporate pension schemes to have recognized what was about to happen—and be prepared to cope—would have been some feat, says Andrew Kirton, global CIO for investments at Mercer.
“About 12 months before Lehman Brothers collapsed, a client had asked about counterparty risk, and we produced a paper about what would happen if one went bust,” Kirton says. “Our paper said that all hedging solutions would be fine. Of course, we discounted the idea of a systemic banking crisis…”
So what did pension funds learn—apart from to expect the unexpected?
“Pensions realized that governance matters when making quick decisions—you can be faced with an odds-on piece of advice, but you have to move quickly,” Kirton says. “Volatility throws up opportunities, but you need a way to capture it.”
One beneficiary of this volatility has been outsourced, or fiduciary, managers.
“Those controlling pension funds have also realized the investors’ need to be able to operate with a sensible amount of autonomy,” says Clare. “There is no point in them having to check every decision with the board.”
“Asset managers are diversifying, as are consultants—even those who maintained that they would just offer advice have begun to offer investment management, or OCIOs,” says Turner. “Everything is ballooning to take over from plan sponsors. Sponsors still need to worry about risk, but there is now a wider range of providers that can help them implement strategies to mitigate it.”
Tire manufacturer Pirelli agreed to take on consulting firm Cardano as its fiduciary manager—not to avoid any other type of de-risking but to make it happen more effectively. “We do not see fiduciary management or outsourcing as alternatives—rather, the contrary,” says Flavio Cateni, European controller at Pirelli. “Fiduciary management is a way to better manage LDI, and its scope could be—and normally is—allowing a buyout when self-sufficiency becomes near enough not to make it too expensive.”
Rapin at TRW Automotive credits its pension consultants with the success of its LDI program. “The timing had a lot do with our advisers—they were paying attention to it. We were happy to be in a good funding position, so we were not as sensitive as others to financial markets. In fact, if we had not moved to LDI, and stuck with equities, we would be in a better position—but there are trade-offs that you have to make for protection.”
However, some think there are too few corporate pension sponsors ready to make this trade-off. “Some people are still waiting for ‘normalized’ rates, whatever these may be,” says Frank. “It is the second time in a decade that investors were handed the same lesson, but they are still holding onto risk, as they seem to think there will be a less expensive way to hedge if they wait. But by not hedging they are actively taking risk. I’m not sure they realize it could get worse.”
Penny Green, CEO of the Superannuation Arrangements of the University of London (SAUL), agrees: “If you had started LDI in 2007, when funding levels were okay, you would have been a lot better insulated. Okay, if you do it now you’re closing the door after the horse has bolted, but pension funds still have horses in the stable and they should be trying to protect them.”
SAUL entered into an LDI program last year that uses a series of triggers to lock in at predefined levels.
“The trend toward LDI would have continued, but the crisis accelerated its progression,” says Clare. “It reminded pension funds that equities are not what they need—don’t buy into optimism. Pension boards have up-skilled dramatically over the past five years. Consultants have had to re-educate—and be re-educated—about what asset classes can actually be used for, for example.”
The LDI landscape itself has changed due to the crisis. Investment banks that had once touted their wares to pension funds have quietly withdrawn from the market.
“There is a cultural gap between investment banks and investors,” says Green. “Investment banks are driven by transactions. Pension funds want a relationship. There were already conflicts of interest appearing—for example, giving advice on a transaction and then the same bank carrying it out… The consultants have upped their game in this regard and have taken a bigger stake in the market.”
Frank says there was a realization by the banks that their opportunity to carry out direct trades was limited—hence the retreat. But they did add to the industry: “Banks raised the game of the market overall, and much of that knowledge has gone back into the asset management and consulting industry,” he says. “Some of the consulting firms have made great strides, but it is the key decision-makers in the pension funds that have had to make similar ones, too, for the impact to be felt.”
Lehman Brothers’ collapse did not cause the pressure on corporate pensions, but it did intensify it. For those who have accepted this increased burden and are dealing with it, the next crisis may not be as brutal as 2008. For those who have not, the next wake-up call may come too late.