Chasing new rainbows?
In the last two years, investment banks have truly woken up to the fact that there is a vacuum in the investment product range offered to pension funds. Many houses have set up dedicated pensions groups, and all of them are vying for new business. Some are finding it harder than others however. Mandate wins range from about four a month to 12 a month, and many consultants want investment banks to try to simplify their product pitches.
“Investment banks need to present their products in a much more simplified way. Many pension funds find it difficult to understand liability based products, because pension funds are fundamentally tuned into equities and bonds, and anything out of the ordinary is seen as chasing a new rainbow,” explains Amin Rajan, chief executive officer of Create, the UK-based research consultancy.
Traditionally, investment banks have focused purely on liability management, but now that product range has expanded. In 1999, for example, UBS set up its Life and Pensions Solutions Group to focus purely on liability management. It was beefed up in 2004 to include other solutions as well.
“What we have found in our projects around Europe is that each country brings different risk exposure, but that pan-European regulatory requirements increasingly demand an integrated solution,” explains the group’s Rupert Brindley.
Kevin Rush, head of the European Life and Pensions Advisory Group at Credit Suisse First Boston, says the firm uses a range of different products to meet pension fund requirements. “The tools that can be used to address a client’s pension issues are quite broad. We can use interest rate swaps, inflation swaps, equity derivatives, government bonds, options, letters of credit or guarantees, credit default swaps, and then the whole range of corporate bonds and CDOs.”
They are used to help with a pension scheme’s funding issues, provide risk management and liability driven investments, and offer effective asset allocation decisions, explains Gareth Derbyshire, managing director of the Insurance and Pensions Solutions Group at Merrill Lynch. Pension funds are facing severe deficit problems, and, says Derbyshire, “Investment banks have always had expertise in terms of raising capital. If you are a company looking to issue debt, it’s the investment banks that you go to”.
The use of instruments such as swaps and hedging for risk management and liability matching have caused some consultants to point out that the more exacting pension funds try to be using derivatives to match assets, the more their costs will rise. They warn that pension funds must consider the financial implications carefully.
Others suggest that funds should be careful to ask where their risk is going. “If you are taking risks off the hands of the pension funds, where are the risks going? It’s not like they are staying on the balance sheet of the bankers. I assume they are parcelling it out to someone else, maybe hedge funds. And I wonder if pension funds are not buying the risk back by investing in hedge funds,” suggests Yariv Itah, a director with Casey, Quirke & Acito, the US consultancy.
Investment banks also claim they can help diversify allocations more effectively. “The average UK pension fund is still concentrated in equities. The risk this implies can usually be better diversified. This doesn’t necessarily simply a ‘less risky’ strategy, just better risk management,” Derbyshire explains. The process could include greater allocation to alternative assets, or structured credit, but, he adds, there needs to be education on some of these products across different European countries.
Still, pension funds have expressed their interest in structured solutions. Last year, a report by BNP Paribas revealed that more pension funds want to increase their exposure to collateralised debt obligations and asset backed securities. 17% of respondents to the survey had increased allocations to CDOs the year before, while 61% said they would be doing so in the future.
Banks say that, at present, LDI solutions are the most in demand. “We have worked on a pretty broad range of mandates. The most popular at the moment is the design of some matching strategies that allow clients to take advantage of yield enhancement, through credit strategies with inflation linked swaps,” explains UBS’s Brindley.
But asset managers and consultants have criticised the banks for “pushing unnecessary products” and going into marketing overdrive. “I certainly have been inundated with marketers,” complains a pension fund manager at one UK scheme.
And investment banks are quick to point fingers as well. “Normally, you’ll find that structurers either sit with the traders or marketers and are restricted by what products they can show or motivated by the trading books. Our structuring teams have been set up such that they are independent of individual products and have complete access to all the tools in both fixed income and equities,” says CSFB’s Rush.
For the banks, there is certainly everything at stake. Goldman Sachs, Merrill Lynch, and Morgan Stanley are said to be the biggest investment bank providers in the market, but the competition is nipping hard at their heels. “Investment banks are going after the same business. Not all investment banks will make enough money to justify the overhead. Don’t forget the pension scheme has got to be large enough for the bank to be able to execute a chunky deal – it just doesn’t work for smaller schemes,” says John Ralfe, an independent pension consultant. He also points out that there are only so many pension funds in the market, and that saturation will be inevitable. It is a comment that investment banks dismiss.
“In principle, market saturation may become a valid concern in five years time. In practice, I think that we are closer to the start of a boom in risk management offering than a bust,” says Brindley.
For his part, Ralfe dismisses critics who say that pension funds need to consider the fact that banks are making profits from any executions and have conflicts of interest. “Investment bank advice must lead, eventually, to a transaction on which the bank makes money. But the conflicts of interest within a bank are much more transparent that with the traditional actuarial consultants,” he says.
Investment banks are also facing competition from asset managers. Casey, Quirke & Acito’s Itah believes that banks will not survive in the market in the long term. “You’ll have asset managers picking up those skills that today they lack. What’s more probably is that there will be a skill migration from banks to the asset managers, and eventually the smart asset managers who get there first will own the relationship,” he suggests.
It means that now, more than ever, investment banks must be able to sell the logic of their products to pension funds. Says one UK pension fund manager: “they are often too busy trying to sell their products to explain them properly.”
But banks remain optimist. “I think it’s a worthwhile business for banks. Most transactions are not outlandishly profitable, but its very much a function of how much customisation and risk transfer is happening,” says Brindley.