A walk on the wild side
It’s Christmas Eve 2005. It is raining cats and dogs outside and the UK equity market is heading for its worst year since 2001 with a fall of 23%. Curiously, Tony, the pensions manager of Smartco plc, is smiling with his feet on the desk, for this is the best year for his pension plan since the heady, gung-ho days of 1999. Back then, men were men and pension managers held shed loads of equities without a thought for their liabilities.
Tony recalls the awful day close to Christmas 2001, now a part of the folklore of Smartco, when his predecessor headed for the finance director’s door with his heart in his mouth. For this was the day when he had to admit finally that the contribution holiday was over and Smartco had to find £100m of contributions in 2002. The chill that spread over the pension department as the finance director ranted and raved will never be forgotten.
The finance director – we’ll call him Chris – was smart, if a little hot-tempered. He had a first in physics from Cambridge, a DPhil from Oxford and an impeccable MBA from the London Business School. It didn’t take him long to work out what had happened. Smartco wasn’t doing anything unusual with its pension plan. In fact, it was a perfectly conventional fund with 75% invested in equities and the rest in bonds and property. It was so conventional that he hadn’t even given it much thought, but he should have done.
Instead, lemming-like, Smartco had followed most of the rest of the pensions industry by making the huge error of mistaking luck for skill. For 20 years, equities had produced great returns and no one had given a thought as to why. Why were the returns so good and why was the pension fund invested in them?
Chris knew perfectly well that, to his staff, a pension was no more or less than deferred pay. He also knew that, ultimately, deferred pay was a liability of the company. If the fund ran out of money, the company had to cough up, just as it was having to do now. And, with life being what it is, this £100m was going to have to be found just when his company’s profits were collapsing. And this wasn’t coincidence. Equity markets were falling, mostly because earnings were collapsing, not just Smartco’s, but almost everyone’s.
The light went on. Completely unawares, they had created a double jeopardy which could bring down the whole company. They had to pay up just at the time when they could least afford it.
It was hot in the office, but Chris felt an icy chill as he realised the astonishing risks they had been taking. He called Tony, the only independent thinking investment manager Chris knew, and the only one who had the technical skills to keep up with Chris.
Together they began to throw ideas up against the wall. They had to cut risk by bringing the assets more in line with the liabilities. Who cared whether their equity portfolio outperformed the FT All Share index? What mattered was whether they outperformed the liabilities. Why worry about outperformance at all, when the real worry was downside risk - the risk of a shortfall?
But if they could cut the risk, would they have to pay a huge price in terms of returns or the cost of providing benefits?
Gradually, the white board got covered in equations. They were managing a hedge fund and they hadn’t even realised it. The pension fund’s liabilities were just like debt and equivalent to the leverage taken on by a hedge fund. But the asset structure looked nothing like a hedge fund at all. In fact, the core/satellite manager structure, so much favoured by the pension industry, made managing this particular “hedge fund” well-nigh impossible.
Absolutely no-one was thinking about what really mattered for their fund and for Smartco. Portfolio managers were worrying about their particular narrow briefs. The consultant was worrying about asset/liability models, and the trustees were relying on their consultant and their managers.
There was a whole raft of matters that should have been on someone’s agenda but were not: shortfall management, contribution volatility, balance sheet exposure, even bankruptcy risk. These risks could be managed. Indeed very similar kinds of risks were being handled by hedge fund managers day in, day out.
A dim grey dawn began to break the night sky and it was still raining, but for Smartco it was the beginning of a new era. Tony joined the company. No one could understand why he would leave a well-paid City job to become an in-house pension manager, but then they didn’t know that his compensation was directly linked to the surplus of the fund and the contributions the company had to make. Within two years Smartco’s fund was entirely reconstructed. Gone was the core/satellite structure, and the consensus allocation.
Instead, Smartco’s fund included large quantities of debt, both fixed rate and inflation-linked. And with marketable inflation-linked debt scarce, much of it was in the form of privately negotiated placements. Smartco’s fund manager line-up included a raft of absolute return, hedge fund strategies with a number of market-neutral, long/short strategies.
And the long-only equity managers knew they would be judged purely by their alpha generation. Tony took all market exposure responsibility away from them, running a dynamic hedging programme to match Smartco’s downside risk appetite. Every person in the chain was now remunerated in line with objectives which tied back to the pension fund’s and Smartco’s goals.
What had the rest of the pension world been up to? A large group had done absolutely nothing and now, for the second time in just five years, there were going to be some very unpleasant conversations as finance directors faced up to having to top up their pension plans once again.
A significant number of companies had simply given up and walked away from accepting defined benefit (DB) responsibilities, sponsoring defined contribution (DC) plans instead. Here was the next minefield. Some of these plans had been around now for a decade or more and for the first time were about to experience significant numbers retiring. With the miserable returns from equities over the past five years, many faced retirement with totally inadequate pensions and no possibility of making up the difference from any other source.
Only a few companies like Smartco had woken up to what was happening first time around in 2001 and had dodged the second bullet by re-designing their plans in the nick of time. For them, offering a well-funded and solvent DB plan was proving to be an enormous bonus when recruiting. Increasingly, as more and more retired in relative poverty, others in work realised just how important that deferred pay commitment really was.
And the real reason why Tony was smiling? This was his last week in work and he was only 55.
Alan Brown is group chief investment officer, State Street Global Advisors