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Shock factor

Liam Kennedy spoke with Theo Kocken and Kerrin Rosenberg about pensions, behavioural finance and a new definition of fairness

Cardano’s CEO, Theo Kocken, likes to shock audiences with a slide showing how hard it is for an underfunded pension fund ever to recover nowadays.

His data depicts the reality of low bond yields, volatile financial markets and an ageing society, in combination with the fact that even open DB pension funds are becoming cashflow negative as they enter the payout phase and can no longer rely on the myth of long-term expected returns.

It compares unfavourably with a second slide, showing how easy it was, comparatively, for pension funds in the 1970s and 80s to escape underfunding. They were cashflow positive, enjoying higher yields, lower longevity and bouyant equity markets.

“I showed the slides in Japan and they were flabbergasted. Japan, of all societies, is vulnerable to the payout phase they are in, and even they were surprised. Every time I am in the UK, I am surprised by the effect the slides have. I know it’s a behavioural finance thing – it’s called aversion to a sure loss. If you are in a sure loss you want to bet yourself out of that sure loss before you de-risk. And that has brought many people into deeper trouble.”

Like a patient with a slow-onset illness like heart disease, many defined benefit pension funds have slipped steadily into a more underfunded position in recent years. The major factor is low bond yields but in the UK this has been exacerbated by investment strategy – funds entered a period of poor equity markets with a high strategic exposure to the asset class – as well as falls in their contributions as they closed to new and existing members.

It’s easy to say with hindsight that pension funds should have de-risked prior to the current crisis, in 2007 say, when, in the UK, they enjoyed an aggregate surplus, as did their Dutch counterparts. As Kocken points out when he refers to “aversion to a sure loss”, it is hard to get out of a losing position, since human nature – something to do with our inherent optimism and a tendency to believe our powers of judgement are better than the average – tell us that we should wait until circumstances improve.

Kocken’s slides, furthermore, are intended to shock audiences into realising that even if you do wait for an improvement in interest rates and equity markets, you will never be able to recover your funding ratio.

He also likes to use the analogy of ‘sinking giants’ to describe the challenges of pension funds ill-equipped to cope with the financial risk implications of an ageing society. As his slides show, and just like the onset of an illness like heart disease, when you do recognise the patient is ailing it is often too late to do anything – either because the patient is too ill or so set in his ways that he is disinclined to change his behaviour.

Kocken’s right hand man and UK CEO, the ex Hewitt consultant Kerrin Rosenberg, has been working in the UK long enough to understand the learning deficiencies of the country’s occupational pension system. He left Hewitt in 2007 to join Cardano after 15 years as a consultant.

Rosenberg chooses to diagnose the problem in specific terms. In June 2007, when Cardano started in the UK, pension funds had a surplus of £140bn (€174bn) according to the UK Pension Protection Fund. By the end of June this year, that had widened to a £270bn deficit. Taking into account the £60-70bn, or so, in special contributions that Rosenberg reckons have been made over that period, there has been a deterioration in the financial position of UK pension funds of up to £500bn.

So why are UK pension funds not embracing the kind of fiduciary and risk management offering of Cardano and its competitors? That takes Rosenberg and Kocken again straight back to the “aversion to a sure loss” – trustees are afraid of locking in that loss, implicitly admitting that their strategy was wrong. It’s always tempting to hold on, like a gambler with an unlucky streak, for the winning card, which would be a happy conjunction of a sustained equity bull run and higher interest rates.

“That logic has been false for almost the last 10 years in a row,” notes Rosenberg, who has a 10-year track record in pension de-risking, having worked on the landmark Boots derisking deal 12 years ago with John Ralfe.

“In the UK, talking to pension funds today, there’s a huge sense that they are not where they want to be, not just from a funding perspective but also from a risk perspective,” Rosenberg continues. “But one of the things I have underestimated is that simply recognising that one has a problem isn’t a sufficient precondition for change, even when you can present a credible alternative.”

He sees a need for better education on the behavioural finance issues that dictate that needing a return involves taking greater risk. “Just because you need a return doesn’t mean you should take actions that have unbearable consequences if they go wrong.”

A lot of pension funds are betting on plan A – for interest rates and equity markets to bail them out. But as Rosenberg asks, “what’s plan B if we do end up in volatile weather and low equity market returns?”.

Sometimes people position fiduciary management as a solution to the governance problem faced by pension funds and issues like slow decision-making. Rosenberg likes to turn the question around: if fiduciary management is the answer, what was the question? For Cardano the issue goes back to risk management.

So for Cardano, the plan involves, simply, better risk management, which, in an ideal world, would avoid the need for a plan B – certainly not fiduciary management in the narrow sense of some of the pre-2007 contracts. The firm’s own interpretation of fiduciary management – solvency management – is now actively offered in the Dutch market as well as in the UK. Rosenberg started offering it in the summer of 2007.

Cardano – named after the sixteenth century Lombard mathematician Gerolamo Cardano, who is remembered for his work in probability and algebra – was founded in 2000 as an adviser on risk management and derivative overlays and currently supports over €100bn of derivatives overlay programmes and provides fiduciary management to eight UK clients with assets worth over €10bn. Aside from pensions advice, derivatives overlays and solvency management, the firm also has capabilities in hedging of currency, catastrophe and commodity price risk in frontier markets.

What has Kocken learned from a pension fund market than contrasts with that of the Netherlands? “A funny thing that is remarkable to me has to do with culture and society,” he says. “In the Netherlands, we have been trying to solve the pension problem for the last 10 years and we have a vivid discussion, quite a hard discussion, but we solve the problems step by step and get closer to a solution. In the UK there is a tough discussion between people, daily media fights about how to solve the problem, then nothing happens. In the Netherlands, we started with conditional indexation after the tech bubble. Even though the funding levels were quite high, people realised we couldn’t pay full indexation.”

“There are a lot of solutions that could make the patient a lot healthier and we think patient UK is pretty unhealthy,” adds Rosenberg. “Unfortunately the problem requires some legislative change because we have this very inflexible system in the UK with no outlet for underfunded schemes other than the PPF which is a controlled default situation.”

Kocken takes up this thread: “This spurious protection is not protection for all and there is a systemic problem in the UK. The PPF is not meant for a systemic problem, it’s meant for idiosyncratic problems. So what’s left is either a very bad situation where people born after the 1960s and 70s won’t get their pensions, or there will be a new design of the contract.”

Kocken wrote his PhD thesis, published under the title ‘Curious Contracts: Pension Fund Re-design For the Future’ in 2006, on risk sharing within pension funds, emphasising the unique nature of that risk sharing between active members, retirees and the employer. He regularly appears in the Dutch media to emphasise the inter-generational nature of the pension promise, initially fighting the corner for younger generations often overlooked by politicians who have a vested interest in skewing pension policy to secure the votes of retirees. “However, it has now become a more balanced discussion since the current minister of social affairs, Henk Kamp, ordered that adjustments in the pension law can only happen without unfair inter-generational implications,” Kocken adds.

As Rosenberg puts it: “This is not a left versus right discussion, it’s a ‘do we understand the generational issues or not’ discussion.” Understanding the issues, and overcoming some of the behavioural biases inherent in the decision-making of pension funds, would go a long way to helping pension funds meet their obligations in the near term. That, in turn, would contribute to creating a better and more robust pension system in the longer term.

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