mast image

Impact Investing

IPE special report May 2018

Sections

DB back from the dead

When hedge funds, investment banks and private equity firms get involved it’s a sure sign that there’s some potentially serious money to be made. So what’s the hot new market they’re looking at? You might be surprised to learn that it’s the previously unglamorous field of defined benefit (DB) corporate pension funds.
That’s right, these financial market hotshots are putting their weight behind several different ventures that are in their various ways looking to tap into the potential of moribund defined benefit funds. The Pension Regulator has said that alternative asset managers such as hedge funds and other operators of special finance vehicles are looking at the viability of taking over company pension fund liabilities. “We are aware of these proposals,” it says. “It is something we are watching very closely.”
Such new entrants would effectively take the problem off its hands, because they would be regulated as life insurers and thus come under the remit of the main financial watchdog, the Financial Services Authority. This sort of upheaval of the pensions landscape has not been programmed in to any existing legislation, so in effect it’s a way for the new providers to sidestep existing complex rules.
Where the government and the industry itself has failed, these newcomers are looking to help companies sort out their pensions problems - and no doubt make a tidy profit in the process. In a typically British fashion, it appears that there’s a market solution to every problem. But how members - as opposed to the plan sponsors - will react, is at the moment an open question.
The new entrants plan to buy-out pensions from their corporate sponsors and make use of economies of scale to ensure the deals work. It raises the notion that hundreds, if not thousands, of individual schemes could eventually be lumped together and run by a handful of specialist companies. All of which makes the recent talk about ‘sponsor covenant’ at best an interesting diversion. The Department for Work and Pensions has so far remained quiet on this point.
The whole issue has come into focus, as is widely known, by a confluence of factors: increased longevity, low bond yields and the market crash in the early part of the decade. And then of course there are the accounting standards, which have explicitly put pension deficits on the balance sheet and on the radar screen of the finance director in a new way.
Not everyone however is convinced. Actuaries at Aon Consulting for their part have expressed some scepticism about whether the idea would work in practice. Senior actuary Paul McGlone says: “I’ve heard it’s not as easy as originally thought. How can they do it at less than buyout when an insurance company can’t?”
One assumes that the new entrants have done their sums and are persuaded that there is a profitable niche to exploit. So how big is the potential market? The firms are looking at a market that comprises around 10,000 company-sponsored defined benefit pension schemes with an estimated £1trn of liabilities and some 14.9m members. Companies in the FTSE 350 index are said to hold around £422bn of pension assets. It comes in an environment where 63% of firms say their pension deficits have a “significant or severe impact on reported profits”.
There are believed to be at least five groups involved in the area. They include Clive Cowdrey’s Resolution, and entrepreneur and financier Hugh Osmond’s Pearl Group - which recently hired ABP’s capital markets chief Jan Straatman to spearhead its push. Resolution and Pearl take on life insurance assets - the so-called ‘zombie funds’ - although Straatman’s hire was a clear signal of intent to enter the pensions arena.
Then there’s Duke Capital, former Prudential UK chief executive Mark Wood’s Paternoster and something being put together by another former Pru executive, Isabel Hudson. Details are scarce at the moment but Paternoster, which appears to be the most advanced, has gone public with its plans.
In April it announced that it had secured £500m (€721m) of financing from a consortium led by the investment banking arm of Deutsche Bank. Also involved were a hedge fund – Eden Park – and some senior figures from the UK’s finance establishment. These included Sir Howard Davies, the former head of the FSA and Jeremy Goford, the former president of the Institute of Actuaries.
The Pearl Group is backed with private equity money.
It will be ironic indeed if it’s private equity and hedge funds that eventually come to the rescue of the beleaguered mid-sized pension fund of UK Plc. They’re the kind of investments they themselves would not have access to because of their size.
Incidentally, at a swoop, Paternoster would appear to have roughly the same amount as the Pension Protection Fund. The funding announcement was one of the first concrete developments in this nascent area.
Paternoster will effectively be run as a new life insurer - the first to be launched in the UK in some 30 years. Wood has now gone on the record to explain his business model in more detail. As expected, Wood says the focus will be on generating economies of scale – which he estimates to be potentially “massive”.
“We put them together and then the efficiencies of administration and asset management come to the benefit of the pensioners,” Wood says. “We are most valuable to medium-sized companies and by putting a lot of medium-sized pension funds together clearly we can get massive economies of scale.”
He adds: “Essentially companies will look at the costs of their obligations under the DB schemes right to the end where a scheme has been closed. We’ll work with them on making an assessment about the life expectancy of people within the scheme and also the investment returns that can be achieved from their portfolio and then agree with them a price for the transfer of all of the risk from their balance sheet to our balance sheet.”
In effect Paternoster plans to acquire and then invest the assets. But what about guarantees to members? Wood says: “Well of course a defined benefit pension within a company is really no more than a promise and it depends fundamentally on the strength of the individual company, the cashflows, the profitability of that company.”
“And rather surprisingly in a sense there’s relatively little capital that sits behind the promise that is made to pensioners. When the scheme transfers to us as a UK-regulated insurance company under the control of the Financial Services Authority we have the obligation to put substantial capital behind the promise that has been made.”
He explains: “So the company transfers the promise to the pensioner into Paternoster and we carry the capital to back up that promise.” And he reveals there has been a lot of interest in the project from companies looking to transfer their pensions as news of the project has emerged.
He says: “You’d be surprised by the number of companies that have approached us for quotes. Indeed we’ve been surprised by the number of calls we’ve had over the last few days. Last year there were probably something like 250 transactions.
“But this year with the introduction of the Pensions Regulator and the Pension Protection Fund levy, and indeed changes to the FRS17 accounting basis, companies are looking afresh whether its right to have a DB scheme on the balance sheet or whether a move like this is a worthwhile one.”
The imminent arrival of Wood’s outfit and the others comes amid the wider debate about pensions in the UK, triggered by the Pensions Commission’s various reports.
The occupational pensions system in the country has long been held up as an example. But now, thanks to a variety of factors, it could be facing perhaps its most profound change yet with the new providers. Interestingly perhaps there has been little real discussion about what are the potential longer term consequences of such a momentous shift.
Indeed, the entire model for the second-pillar would be under scrutiny as never before, with a life insurance regime in place instead of the traditional funded method. Whether this is something to be welcomed or feared, is as yet, too soon to say.

Have your say

You must sign in to make a comment

IPE QUEST

Your first step in manager selection...

IPE Quest is a manager search facility that connects institutional investors and asset managers.

  • RE-2441

    Closing date: 2018-05-31.

Begin Your Search Here