Risk manager or trusted adviser?
Across Europe, the pensions landscape is ostensibly one that conveys difficult and unwanted messages. Liabilities are typically large in comparison to the market capitalisation of sponsor companies. Schemes are generally poorly funded. From an adviser’s perspective, risks are also large due to the volatility arising from mis-matched asset mixes and the deterioration of sponsor credit worthiness. These problems are well known in the UK and while countries like the Netherlands and Sweden present a slightly rosier picture, the emergence of these issues in countries such as Germany is new cause for concern.
At UBS Investment Bank, our take on this picture is essentially four fold. Firstly, sponsors need to agree to a funding strategy for these liabilities and for the removal of deficits. Secondly, an agreement regarding asset allocation should be reached, which addresses the extent of underfunding, the contribution programme and the credit rating of the sponsor. Thirdly, there needs to be a thorough understanding of the risks posed by non-matching ‘growth’ assets. Finally, there should be an analysis of how and when the full extent of the liability will be matched with apposite assets.
These measures will help preserve capital and improve funding positions.
So where does an investment bank fit into the equation? Figure 1 illustrates the crowded market place that exists in the UK. The investment bank has to prove itself to its three key clients, the sponsor company, the investment consultant and the asset manager. These can be taken in turn.
Investment consultants have made great strides towards achieving a deeper understanding of the solutions that investment banks have to offer their clients. The increased flow into newer derivatives, which would not have been on the pensions radar just a short while ago, is evidence of this greater depth of understanding. For example, the exponential growth in the inflation swaps market in both the UK and Euro-zone, is testament to how investment bank innovation, married with consultant understanding and foresight, has already benefited a vast number of pensions arrangements. In addition, the further development of highly rated structured credit (such as leveraged super senior notes) has also been of benefit to those with the foresight to recognise that this can – when properly constructed – significantly enhance return in an uncorrelated manner.
Asset managers, from the UBS Investment Bank viewpoint, are partners in this innovation. Bringing together the capricious hand of the capital market and the longer-term fiduciary stability of the fund manager has resulted in some positive outcomes. Under the watchful eye of an experienced, knowledgeable asset manager, we have seen a number of clients move confidently into innovative derivatives and rewards structures.
As regards sponsor companies, historically, this is where investment banks have the strongest relationships. Typically, most of the tools employed by the investment banks are not new to this client, particularly in the areas of interest rate and FX derivatives. Having an investment bank assist the sponsor’s finance team with the pensions funding conundrum is, for many, a natural extension of the existing relationship. A trusted adviser is often a useful addition to the sponsor’s decision making process, if only to act as a sounding board for some of the views emerging from the relationship between investment consultant and the trustee body.
Importantly, the investment bank must bring four key qualities to the relationship, be that with the asset manager, the consultant or the corporate sponsor; these are: innovation, analysis, adaptability and risk management.
Innovation through products and thought leadership is a natural fit for the investment bank. The investment bank, it should be remembered, is viewing contrasting financial puzzles across many thousands of clients in very different sectors on a daily basis. Introducing product solutions from one area to another is a simple way to innovate. The cross-fertilisation of a wealth of ideas is one of the many ways in which this innovation can be achieved. For example, the US market has traded in short-dated inflation derivatives for many years and the euro market has traded by way of retail products for the last five years or so. Bringing this technology to the attention of pension funds, albeit with longer duration requirements, has created a new paradigm in linked liability hedging.
Analytically, the investment bank must be able to characterise the financial problem faced by the respective agents and present a market consistent summary of how this can be valued, hedged or risk transferred. Figure 2 illustrates the manner in which the current deficit position of a corporate may be compared relative to its peer group and against its net financial result. At a glance, this describes the relative position of the corporate, along the perilous state of its own financial situation. If you can envisage that this may be modelled as a stochastic variable, you can begin to see the importance of risk analysis.
Adaptability is that necessary Darwinian attribute without which investment banks would not survive as trusted advisers. The ability to focus on point solutions, allied with the ability to switch these around as the client decides to alter objectives and/or financial drivers should be a given. A bedrock of solid financial modelling techniques and links to real world hedging applications is the only way in which the investment bank can offer this adaptability.
Risk manager and trusted adviser
Risk management is inherent to investment banking. Solid risk management enables the investment bank to access offsetting positions in a way that delivers best execution and value to its clients, whether this is the sponsor or pension scheme – either directly or through an asset manager. Delivering this under the watchful eye of the consultant is an increasing requirement, which the best investment banks are able to live up to.
In summary, UBS Investment Bank sees a partnership approach continuing to gain momentum. We believe that these partnerships, focussed on innovation and added value, will genuinely make a difference to the current parlous state of European pensions. Allowing the investment bank to work alongside as a risk manager and trusted adviser can undoubtedly assist in the efficient transfer or re-packaging of financial risk. This position is only attainable through the adequate demonstration of genuine innovation and the building of trust. Whilst innovation is easily demonstrable, the building of trust is a tougher hill to climb and only a few, with the requisite financial integrity, will continue to remain at the top.
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