Rules trigger CTA boom
To the delight of Germany’s asset management industry, the much-anticipated boom in corporate pensions finally happened last year. And as 2006 begins, it shows no signs of slowing.
Interestingly, the type of boom is not what one would normally expect. While corporate pensions have spread dramatically since historic pension reforms in 2002 gave each worker a right to a defined contribution scheme (DC), the volume of pension assets has not grown much. Since 2002, the volume is estimated to have increased roughly by a maximum of €50bn to €400bn. This would correspond to annual growth of 12.5%.
Such growth is nothing to sneeze at but hardly constitutes a boom. So why are players in German asset management cheering? Well, while corporate pension assets may not be growing much, there is a boom in the way they are being allocated.
German companies are abandoning the traditional method of financing pension liabilities with on-balance sheet assets and instead creating external funds called contractual trust arrangements (CTAs) for that purpose. Especially in the case of big companies, the process yields lucrative mandates for fund companies, consultants, lawyers and anyone else doing business with German pensions.
First employed by Anglo-Saxon companies in Germany during the 1990s, CTAs have taken corporate Germany by storm. Since 2000, when technology giant Siemens created a CTA with an estimated €10bn in assets, more than 20 companies traded on the Dax-30 equity index have followed suit. In 2005 alone, five Dax companies - Henkel, E.ON, MAN, BASF and Allianz’s Dresdner Bank - set up the funds.
Industry sources in Germany suspect the next likely Dax candidates for a CTA are energy giant RWE, which has close to €12bn in pension assets on its balance sheet, and luxury car maker BMW, which has nearly €3.3bn. If RWE were to create a CTA it would be the biggest ever.
While there are many factors driving the boom, the main one has been the switch from German accounting rules to international accounting standards (IAS). Since 2005, all German firms that raise capital on financial markets - whether with equity or bonds - are obliged to adopt IAS. For those reporting under US-GAAP, a switch to IAS is required from 2007.
In making the switch, the 20-odd Dax companies have chosen CTAs for their pension liabilities, as IAS generally treats those left on the balance sheet as unfunded. The rating agencies, including Moody’s, Standard & Poor’s and Fitch, have reinforced this trend by lowering the credit ratings of firms that still rely on internal funding of their liabilities.
Indeed, partly to maintain their good credit ratings, several non-listed companies have opted for CTAs. Two prime examples from 2005 are the media conglomerate Bertelsmann and DZ Bank, a Frankfurt-based bank with €400bn in balance sheet assets.
Now, Andreas Folgner, a senior consultant at private bank HSBC Trinkaus & Burkhardt, sees great potential for CTAs among medium-sized companies traded on Germany’s MDax equity index.
“The same is true for those (30 technology stocks) traded on the TecDax and all other listed companies. Especially following the advent of IAS, all these firms will consider whether a CTA is the best way of meeting their pension liabilities,” he told IPE in a recent interview in Düsseldorf.
Excluding the five Dax companies that created CTAs in 2005, Folgner estimates that the vehicles account for25-30% of the €222bn in assets that, originally, were on corporate Germany’s balance sheet.
The case for a CTA as the solution to a company’s pension liabilities is a compelling one. Apart from satisfying IAS, the vehicle provides transparency on how pension liabilities are financed, which, these days, is crucial in attracting international capital.
Another advantage, at least in terms of investment flexibility, is that CTAs are generally free from oversight from the BaFin, Germany’s financial services regulator. Other external pension funds, including traditional Pensionskassen and the newer Pensionsfonds, face BaFin-imposed restrictions, although those for Pensionskassen - a 35% cap on equity investment and a 5% cap on hedge fund investment - are more stringent.
The advantages of a CTA do not come cheap. The vehicle might sound like a fantastic idea to finance pensions, but the company must have the necessary liquidity on hand. The bigger the obligations, the more liquidity needed. The company should also be prepared to pay significant fees to the lawyers, consultants and asset managers involved creating the CTA.
Owing to solid profitability in recent years, neither liquidity nor fees has been a problem for big German companies setting up CTAs. This is not, however, true of many members of the Mittelstand, or the small and medium-sized firms that form the backbone of the economy.
Another considerable expense is the price which a company must pay for having its CTA freed from regulation. Once the fund is in place, the firm must insure it against its own possible insolvency. As a result, it pays the full contribution to Germany’s PSV, a body that insures pensions. By comparison, Pensionsfonds, the vehicles most similar to CTAs, only pay 20% of that contribution because of being regulated by the BaFin.
Beyond the cost issue, Peter König, managing director at the German Society of Investment Professionals (DVFA) notes that a key drawback of CTAs is that they are not deployable on the European level.
“The simple reason is that unlike Pensionskassen and Pensionsfonds, they are not regulated. This could be a problem for those (German) multi-nationals that have CTAs but are thinking about creating a pan-European pension funds to realise economies of scale,” König said.
Indeed, some pension experts - such as Nikolaus Schmidt-Narischkin at Deutsche Asset Management (DeAM) - believe that Pensionsfonds are an attractive alternative to CTAs for companies wanting to finance pension liabilities externally.
“The arguments in favour of the Pensionsfonds are considerable. One pays a lot less for insolvency protection yet still has a great deal of autonomy over how the fund invests its assets,” Schmidt-Narischkin said. He also echoed König’s point that Pensionsfonds, unlike CTAs, could be deployed on a European level.
Meanwhile, other German pension experts warn that while CTAs are very much en vogue - partly because of the hype caused by many in asset management - the vehicles are not per se an ideal solution for pension liabilities.
One such expert is Richard Herrmann, board executive at German pensions adviser Heubeck AG. Speaking from Cologne, he said: “The improvements to the balance sheet caused by CTAs may be advantage for some companies, but other companies realise far bigger advantages by keeping their (pension) assets on the balance sheet. That’s because they are free to be used for acquisitions or any other activity which helps to grow the business.
“In addition, it is simply a fallacy to state that a company can achieve a higher return on its (pension) assets by creating a CTA. Even by keeping the assets on the balance sheet, a company can at least achieve the same returns by simply following the same investment strategy and working with the same asset managers as it would with a CTA,” he added.
Finally, Herrmann and other experts point out that just because a company creates a CTA, the challenge of meeting pension liabilities remains. And if capital markets turn bearish, as they did between 2001 and 2003, a CTA can cause serious headaches for the company.
Consider the example of Siemens, one of the first of the Dax companies to create a CTA. To come up with the necessary liquidity, Siemens relied in part on its substantial holdings in electronics firm Infineon, which following an initial public offering in 2000 was one of the market’s best performing stocks. Yet the subsequent crash of the German equity market - which pushed Infineon shares to agonising lows - forced Siemens to come up with other assets to keep its CTA fully financed.
König of DVFA believes that while CTAs will continue to flourish in corporate Germany, the industry will not see the huge volumes it has enjoyed of late. He attributes this to the changing nature of German corporate pensions.
He said: “In the future, firms offering retirement provision will do so not with defined benefit plans but with DC ones, which do not involve keeping pension assets on the balance sheet. An excellent example is the rise of ‘overtime accounts,’ which naturally can be administered by a CTA.”
Overtime accounts enable employees to save the monetary equivalent of overtime hours, unused holiday, cash bonuses or a portion of salary to help finance retirement or any time off from work.
Owing to their low cost to employers and tax-deferred status, overtime accounts are rapidly proliferating in corporate Germany. Bigger firms that have introduced them include car giant Volkswagen, defence and aerospace conglomerate EADS, Deutsche Bank and the German arm of computer firm Hewlett-Packard.
Schmidt-Narischkin at DeAM agrees with König that the future of retirement provision in Germany will be dominated by overtime accounts. “That’s because employers and unions in nearly every major industry - chemical, engineering, automobile and banking - plan to introduce them,” he said.