Jury is out on regulators' actions
Whether you are reading a newspaper on the London underground or in a Milan coffee shop, the headlines may be different, but the translation is the same. “Pensions in crisis”… “Pension industry time bomb”….
Equities markets have been in relative free fall since the turn of the new millennium as economic weakness, accounting irregularities, the events of 11 September and the subsequent wars in Afghanistan and Iraq all combined to shatter the ‘new paradigm’. The stock market woes have been well documented and discussed to the point of exhaustion. Is there anything left to talk about? Governments across Europe think so.
The sharp declines in equity markets have left pension funds Europe-wide in a state of shock. They have seen values plummet and subsequent funding problems rise to the fore. This has prompted governments and other regulatory bodies to intervene in an attempt to ‘solve’ these problems. Is this the right or the wrong thing to do? A jury of pension funds, consultants and asset managers are divided in their verdict.
The approach of governments and regulators have differed considerably across Europe. In the Netherlands for example, regulator Pensioen & Verzekeringskamer wrote to pension funds in September last year requiring then to produce documents showing their asset and liability status. Since then the regulator has issued far- reaching and stringent funding level and investment buffer requirements because it viewed 20% of Dutch funds as being dangerously underfunded.
Dutch pension funds must have a coverage ratio of 105% at all times and have been given a year by the regulator to put this in place. If a fund’s cover ratio falls below 100%, its board of management must take immediate steps to remedy this situation. The investment buffer must be sufficient to cushion the impact of at least a 40% decline in value relative to the fund’s peak benchmark value of the previous 48 months. Funds must also be capable of absorbing a price decline of up to 10% relative to the lowest point of the benchmark in the previous 12 months.
This has infuriated Dutch pension fund associations. The main axis of their argument is that to build these buffers on top of the 105% funding level means that a rise in pension premiums will be inevitable. If funds sold equities to acquire an acceptable buffer then there may be a short-term reduction on premiums. However, a lower level of equities in a pension fund means lower returns in the long term, which in turn will lead to a shortfall in the buffer and therefore again a rise in premiums. The associations also argue that if pension funds in the Netherlands were allowed to have certain periods of underfunding it would not jeopardise pensions in the short or long term but help them find solutions without draconian measures.
Whilst the associations are in agreement with the regulator in focusing on securing benefits for pensioners, they feel that the pension fund system in its entirety is not being fully considered and that a more balanced approach is required by the regulators. It would seem a verdict of guilty has been passed by the Dutch jury.
Another market where regulators are facing a guilty verdict from pension funds is Denmark. Recent newspaper reports state that Danish pension funds’ equity holdings have fallen as low as 14%, from around 44% in 2002, as a result of sell-offs and falling market values. The latter we know all about. In the eyes of Danish market observers, the former is largely due to pressure from regulators regarding asset/liability matching within pension funds.
The belief within the Danish pensions industry is that whilst the regulators are well-meaning, the asset/liability measures they have passed are poorly thought out and are proving detrimental to the long-term interests of both the Danish workforce and the industry as a whole. The qualifying argument behind this belief is that the focus of pension funds should remain fixed on their primary duty, which is to provision for the pensions of tomorrow. To be able to do that, the importance of equities in a pension fund should not be overlooked, as evidence points to the fact that equities outperform bonds over a long-term time horizon.
In the UK, the pensions industry has been faced with a number of government and regulatory legislations over the last eight years. Following the pensions scandal involving Robert Maxwell, the Pensions Act of 1995 was introduced which brought the phrase ‘minimum funding requirement’ into the vocabulary of pension funds and asset managers. This was followed by the Myners Report, which raised the issue of soft commissions and transaction costs within pension funds. Next came FRS17, which stated that all companies must declare their pension liabilities on their balance sheet. In the eyes of many, the UK pensions system has now become bogged down in bureaucracy, expensive to operate and confusing to the employer, commercial provider and consumer alike.
The verdict thus far would appear to be swinging towards guilty by interference. Not so in Switzerland. The Swiss federal social security office, the Bundesamt für Sozialverscherungen (BSV), is recommending both a soft and long- term cure for the problems facing Swiss pension funds. This has been greeted with a generally positive response from the pensions industry.
The BSV will now impose the ‘Zürcher Formel’ to calculate the coverage ratio within pension funds. The formula defines the coverage ratio as the percentage of net assets divided by reserved capital. A coverage ratio of below 90% is deemed as seriously underfunded by the Swiss authorities and is the point at which pension funds must take financial measures to rectify the situation. It is interesting to note the 15% differential between what the regulators believe to be an acceptable coverage ratio in Switzerland compared with the Netherlands.
When a fund is deemed to be seriously underfunded, it will be allowed to reduce payments to pension, with reductions in proportion to the increase in pensions seen during the boom periods. Further measures include higher contributions by employers and employees, with employers having to contribute at least half of the recovery payments. After such a pension scheme has recovered, such pay-ins will be discounted against their regular payments. The legislation also states that schemes will be given up to five years to recover. If this timeframe is likely to create hardship for members, the period of recovery can be extended up to 10 years. These measures are due to become law in the first quarter of 2004.
Similar to the differing coverage ratios, there are further differences in the approach of the Swiss regulator that are worth noting. The burden of reducing the underfunding does not sit solely with the sponsoring corporation. Both the pension fund itself and the employee have a significant part to play. Which is the better legislation very much depends on whose perspective you are taking. The sponsoring corporations would say the Swiss system is more friendly; the pensioner would strongly disagree. The recovery timeframe that is imposed on a fund is also very lenient when compared with the Dutch legislation.
Based on the evidence presented, should governments and legislators on mass be found guilty or not guilty of over-interference in the pension fund industry? When considering the verdict, it is worth noting that a common theme seems to be arising: the apparent dismissal by regulators of the importance of equities within an investment portfolio. Regulators of every nature must realise that they carry a huge responsibility and obligation, not only to the pensioners of today and tomorrow but to the whole future and well-being of the pension fund industry.
As we have seen over the past three years, a prolonged equity bear market has destroyed value within pension funds. However, forcing pension funds, through legislation, to switch out of equities and into fixed interest securities is locking in this destruction in value. Bear markets also provide pension funds with the ability to rebuild value through equity investment.
The argument put forward by the Danish pensions industry in response to the significant switch out of equities being forced on them by asset/liability matching measures is a valid one. In the book Triumph of the Optimists, academics Dimson, Marsh and Staunton state that in the 1950s only the most rampant of optimists would have dreamed that over the next 50 years the real return on equities would be 9% a year. Yet this is what happened in the US stock market.
In their study, Dimson, Marsh and Staunton looked at 16 countries and analysed investment returns within these countries over the 20th century. In every country studied, equities over the long haul beat bonds.
By their very nature equities are deemed a ‘riskier’ asset than government bonds. However, the risk in an investment portfolio, the study argues, can be diluted through international diversification within the equity component of a portfolio. Herein lies the key point – risk within a pension fund, whatever guise it takes, can be reduced through other strategies than simply switching into bonds.
It is interesting to note that, constraints permitting, certain pension funds have reflected on the current situation and are coming up with a rational response. Over the past three years, bonds have become expensive and these pension funds are now realising that they may not want to sell equities. An example of this can be seen in the UK, where Somerset County Council recently stated that it was raising its equity exposure to 80% to “minimise long-term cost”.
Another such example is the Fonds de reserve pour les retraites in France. This French government fund has a tender out in the market place for e16bn. Of this, only e3.6bn will be passively managed; the rest actively managed. Of the e16bn, 55% will be invested in equities, which will be split 38% Euro-zone equities and 17% non-Euro-zone equities. It is very interesting to note the weighting given to equities in the tender, which is high by Continental European standards. The degree of international diversification within this is also worth highlighting. It is clearly evident that a measured approach has been taken in the construction of this mandate.
By forcing pension funds out of equities and into bonds through legislation, governments are laying themselves open to accusations of imposing ‘regret risk’ onto pension funds – ie, the regret that they did not do something sooner.
It would also appear that the longer-term time horizons of pension funds are not being sufficiently considered before the implementation of legislation. The coverage ratio of a pension fund today is not a reflection of what the ratio will be in 10 years’ time. There needs to be an adjustment made for time when considering practical and healthy legislatory change. Regulators need to take into account the duration of a pension fund’s assets relative to the duration of their liabilities. There is a feeling in the industry that today’s picture is being looked at without taking the future into account. Granted this is a huge exercise for all parties concerned, but it is an important issue that should be addressed.
So, in summary, is the current wave of government and regulatory intervention being done for the good of the industry? Legislators believe so. In certain cases the industry thinks so too. In other cases the industry thinks not.
One thing that appears clear is that the spirit of partnership between governments, legislators and pension funds is lacking. Until this spirit is rekindled headlines such as “Pensions in crisis” may continue to appear in our newspapers.
Are the regulators guilty or not guilty? Of course there is also the verdict of ‘not proven’ under the terms of Scottish law.
Alain Grisay is managing director at F&C Management in London