Rating moves into pensions
A decade ago, few participants in European capital markets would have recognised the term credit rating and fewer still within the pensions sector. Today, credit ratings are an increasingly recognised component of investors’ tool-box, but are only just beginning to emerge in a pensions context.
Credit ratings are opinions from rating agencies about the credit strength of individual transactions, such as debt instruments and/or their sponsoring entities. Each rating agency has its own scale, ranging in our case from AAA, awarded for example to most member states in the EU, through to C, indicating imminent default. The key distinction is between BBB and BB. The former include higher grades considered ‘secure’ ratings and the latter including lower grades being considered ‘vulnerable’.
The case for rating financial institutions is self-evident, with the vast majority being subject to formal regulation on the grounds of public interest. Occupational pensions are broadly unregulated or regulated under quite different expectations, particularly as regards solvency. The distinction is intuitively appealing – the primary commercial objective of the non-financial employer is its business and not the provision of financial services. Provision of long-term savings arrangements is restricted to its own workforce and does not include the wider public. However, under current market conditions, many of these schemes are operating with a deficit of assets relative to their liabilities. This would be intolerable for regulated financial institutions but should there be concern as regards occupational pension systems ?
The classic occupational defined benefit pension scheme creates an extended chain of credit-related obligation and expectation across a wide swathe of separate entities. These can include employers, scheme trustees, scheme beneficiaries, pension actuaries, borrowers, issuers of equity, investment counterparties, asset managers and custodians. Any failure along this chain creates potential losses and reduces trust in the overall system. While credit assessments can do nothing to reduce the absolute level of risk, explicit credit ratings can at least illustrate where credit dependencies exist and offer some potential reference point for risk avoidance or alternative choices.
Looking at the individual players, we have:
- Scheme sponsors (employers). Apart from the assets within the pension fund itself and the associated investment income, the principal source of credit strength is the sponsor’s contributions. FRS17, in the UK, has not changed this dependence but has significantly heightened the visibility of the fundamental relationship. Corporate credit ratings for many years have been analysed with allowance for the pension funding obligations. FRS17, we believe – perhaps contrary to broad opinion – actually strengthens the plan sponsor’s credit characteristics. We expect the credit rating of a pension fund to follow pretty closely that of its sponsor – the strength of which will in turn reflect the solvency of, and contribution rate to, the pension fund as well as other commercial factors.
- Trustees. With the formal separation and growing responsibilities of trustees, we believe explicit pension ratings are a useful reference point for their planning of scheme benefits and investment strategy. Equally, the rating of the sponsor indicates the certainty of future contributions. There can be an uncomfortable trade-off in investment terms – weak pension funds need higher investment earnings but are less capable of sustaining adverse investment risk. Calculation of the minimum funding rate, ideally, should reflect both the credit strength of the pension fund and of the sponsor.
- Scheme participants. While individuals’ choices are relatively limited and usually restricted to deferred beneficiaries – decisions about participation in the scheme or transfer out of the scheme are facilitated if both the fund and the life assurer are rated on the same credit criteria and scale. It is widely recognised in the UK that in the event of sponsor liquidation, the position of deferred beneficiaries can be particularly vulnerable. As regards the transfers of entitlements, it is instructive to note that the cost of pensions mis-selling in the UK has effectively been a transfer of £12bn (e20bn) from the financial institutions to occupational schemes and thereby their sponsors.
- Consultants. With two discrete sets of interests in the form of sponsor and trustee, explicit but interdependent credit ratings for sponsor and pension fund remove one dimension of complexity from the relationship. It was interesting to note that one of the problems identified by the Institute of Actuaries when commenting on MFRs was that they could oblige actuaries “to act like rating agencies” in assessing sponsor credit strength.
- Asset distribution and debt. There is increasing emphasis on explicit asset/liability measurement and its impact on pension fund solvency, heightened by the accounting principles embodied in FRS17. With a low inflation, low growth economy, it is likely that the attraction of debt will increase as an asset class. Debt ratings, while a far from perfect pricing guide, do offer a useful metric for yield/risk optimisation as well as an independent measure of overall asset risk.
- Investment counterparties. The traditional investment pattern of pension funds has involved direct asset exchanges and a basic buy and hold approach. The growing sophistication of capital markets is such that similar investment strategies can increasingly be constructed through a diversity of routes using synthetic products. This development creates the interesting position where the counterparty such as a bank now has a direct interest in the credit strength of the pension fund as well as vice versa.
- Asset manager continuity. While the security of possession scheme assets is rarely a major issue, the unexpected failure of asset managers represents a significant source of operating risk. In the event of asset manager failure, portfolios have to be scrupulously verified and the underlying assets transferred to a new manager and probably custodian. Such events create both confusion and additional costs for trustees. Counterparty credit ratings are one way of identifying and managing such operational risks of third party asset managers.
- Asset manager investment competence. In the search for investment performance and control, investment portfolios are becoming increasingly segmented and assigned to a wide range of third-party asset managers. Many of these managers are boutique specialists – narrow in scope but highly focused in expertise. There would appear to be a growing need for the independent assessment of asset management competence both in qualitative and quantitative terms. With pension consultants taking an increasingly active role in money management, there would seem to be growing opportunities to separate measurement and assessment from the process of investment advice. Similar issues concern the growing use of indices as benchmarks and the independence of their construction and maintenance.
Both the Myners report and contemporary regulatory policy stress the benefits of high levels of transparency and formal separation between the provision of opinion and the creation of advice. While rating agencies do not hold a monopoly on independence, their underlying disciplines of credit risk assessment means that they universally strive towards eliminating any potential conflicts of interest. Equally, they draw a very clear distinction between assessing credit risk and advising how such risk may be managed or mitigated. At a retail investment role, the usually quantitative assessment of product performance is a well established activity. It will be interesting to see whether, with the convergence of retail and institutional investment products, such disciplines are extended by rating agencies into the institutional sector.
By contrast the move towards DC pension schemes usually involves fewer discrete entities, with many of these schemes being provided by regulated financial institutions. Many of these, such as life assurers, already have credit ratings.
This move towards private pensions transfers a very high level of risk and responsibility onto the shoulders of the individual policyholder, both in terms of provider selection and the choice of product. Recent regulatory initiatives in the UK seem aimed at achieving much higher levels of product transparency and wider dissemination of comparative policy terms to redress the imbalance of information and expertise between provider and consumer. The adoption of standardised products incorporating explicit minimum requirements illustrates the alternative approach. The argument is that, although these products may not be sophisticated, they do represent basic good value for policyholders. In either event, it is almost certain that rating agency involvement in this sector is likely to increase in the form of higher credit rating penetration of providers and increased coverage of products.
Finally, and not least, rating agencies are becoming increasingly concerned by the impact of European ageing on unfunded PAYG schemes. Recent projections by S&P indicate that by 2050, without reform of PAYG entitlements, southern European EU member states could incur debt-to-GDP ratios in the region of 225%. At such a level, sovereign debt would enjoy little better than junk status. Clearly, such ratios are unsupportable and will not be permitted to occur. They do indicate the timescale and magnitude of the challenge for which systemic solutions must be found.
For both occupational and private pension schemes, there would seem to be a growing and useful role for credit ratings and analytic investment services. Explicitly assessing risk does not reduce per se it, but can lead to heightened awareness of the uncertainties and adoption of more efficient alternatives and solutions. Rating disciplines have been slow until recently to percolate from the wider capital markets into the pensions sector but this trend now seems irreversible and likely to quicken in pace.
Andrew Campbell-Hart is managing director, financial ratings services, at Standard & Poor’s in London