Just about every occupational pension scheme in Europe, in the UK and beyond has been severely impacted by
the crash of 2000 to 2003. None of the pension fund value chain elements proved to be a shelter for pensioners’ money in funded schemes when protection was needed. Self-appointed masters of financial market complexity at first were perplexed. Then, during the very dead of financial winter in November 2002, overbearing gave way to humility. But soon it became evident that there were a few pension funds in Germany and elsewhere that were in reasonable health.
Everyone then realised what marking to market of funded pensions schemes can do to pension funds’ solvency and sponsors’ corporate balance sheets during extended market downturns. To their credit some investment bankers then conceded that unfunded pension schemes (book reserves) had comparative advantages over funded schemes and that they were more effective for CFOs and more trustworthy for pensioners. Why? Because they entailed no write downs of assets!
In some quarters now anything goes as far as investment opportunities are concerned. Liabilities were ring-fenced by interest rate hedging or outright closing of defined benefit (DB) plans and opening of defined contribution (DC) plans. Judgemental, tactical investment decision-making became the order of the day; strategic asset allocation is drifting out of fashion. Regulated asset classes like listed equity are on the retreat. The belief that salvation lies in risk modelling and in skills-based investment is abundant. Hyper-complexity is on the rise. Personal integrity is key to pension fund success. Global asset management fees exceed $100bn (€84bn). Trustees are left with the burden of ‘zero defect’.
In Germany the crash was felt in specific ways. Book reserves, Pensionsrückstellungen, also known as unfunded pay-as-you-go system, once the preferred and particularly successful German pension arrangement, are on the retreat.
Pensionsrückstellungen are tantamount to perpetual loans by the employees to the sponsoring company – with neither financial covenants nor maturity attached, unlike funded debt incurred from the market. Book reserve money is invested in the operating business of the company. Pensions are paid out of cash generated from operations. Alongside book reserves, funded pensions schemes - Pensionskassen - have a long tradition of merit. Pensions are paid by the fund from contributions and by returns from assets. Contractual Trust Agreements (CTAs), a funded variation without regulatory oversight and yet-to-be-tested corporate governance, have recently leapt ahead of Pensionskassen in terms of amounts of money injected into them.
Having been for too long immersed in a mainly inward-looking system in terms of financial paradigms, techniques and rules, Germany’s financial players, policy makers, regulators and corporations alike since the early 1990s had to catch up with the reality of the Anglo-American world of finance. They had to come to terms mainly with four themes:
q There is a market in corporate control;
q The way investment money is managed today has changed the way corporations are managed;
q Value-based corporate management is here to stay, and
q There are now alien accounting rules to contend with.
Throw in deregulation, foreign share ownership, SEC listings, Basel II, plus rating agencies and it added up to an uphill battle for Germany’s financiers.
Ten years later, in uncharted post-crash financial territory, most of the country’s larger corporations were convinced to move away from book reserves to funded schemes, from DB to DC plans, from regulated Pensionskassen to unregulated CTAs and from regulated traditional assets to unregulated alternatives.
Newly created CTAs were funded with treasury stock of former subsidiaries or real estate, with sometimes unfounded value expectations. Others used cash from spin-offs. Some borrowed ‘fixed to floating, callable, hybrid-perpetual’ big ticket money to externalise their pension obligations, willing to trade corporate finance quick wins against in reality medium-term funding only, with embedded ‘heads the investor wins, tails-the issuer loses’ clauses.
They created for themselves either structural or cost headaches, which surfaced after a 10-year gestation period. Never mind the equity shock in funded pensions, many German Dax corporations increased their exposure to the asset management industry and to ever more complex financial markets. One might have expected the opposite. Unique financial advantages from the internal financing of the operating business via the ‘loans’ from pension plan members to the sponsoring corporation are today deemed inferior to the promises from funded-only pensions schemes.
The concomitant capping of pension liabilities by swiftly closing DB plans and opening DC plans, with investment risk transferred from sponsor to pensioners can be viewed in the light of the German labour market where high-level unemployment has turned the bargaining tables. But will these changes last? Will these corporations have to raise benefits to more equitable after-work income levels, once employees begin to understand the real effects of these changes (FT quote: “Caviar or dog food”) visible in some DC plans in the UK? Will German policy makers leave CTAs with their present corporate governance far off Paul Myrner’s recommendations? Will CFOs and CIOs achieve the hoped-for risk-return goals by putting their trust into ‘rocket scientist risk management systems’ and in a plethora of alternative assets?
Seven ways forward for Germany
1. German corporations should reclaim the systemic initiative by creatively and unrelentingly eliminating home-grown barriers to pensions excellence.
2. They should review their pension schemes and re-establish the optimal mix of funded and unfunded schemes. New schemes are not irrevocable – yet. German corporations are likely to be fully aware that they could make better use of their risk-taking capacity for their operative ventures where PE multiples are higher and where they know the rules of success, rather than investing shareholders’ money in a theatre which cannot be part of their core competence.
3. The book reserve system and the funded system of German pensions should be put to an unbiased shareholder value attribution analysis, free of conflicts of interest.
4. Sponsors and employees should review DC plans, making sure risk-sharing is equitable and sustainable. German CFOs and trustees may want to take clues from the latest breed of Dutch hybrid DB plans.
5. If German CEOs and CFOs believe in funding and in risk management they must recapitalise their Pensionskassen to, say, a 115%-plus funding level as the only way to take advantage of capital market opportunities.
6. They would be well advised to see to it that corporate governance in CTAs evolves to the better end of the inter-national spectrum and to enable process excellence in the management of inter-faces between CEO/CFO/HR/trustees/employees and investor relations. 7. Relying on sublime self-confidence, believing in the long-term strength of many endemic financial ways and means and in more transparency, as well being prepared to say the occasional “No” to Wall Street, the German financial community, including policy makers, may want to overcome the mostly self-organised financial weakness and revise the present over-reaction towards embracing systemic changes in the country’s occupational pensions system – before change becomes irreversible.
Only by unlocking the very best of continuity and change will posterity have reason to be kind to their memory.