Siemens - the never ending story

When IPE first interviewed Herbert Lohneiss, some 10 years ago, he was running the asset management operations of the Siemens group in Munich, through the Siemens KAG(SKAG). The setting up of an independent fully fledged asset management operation under German law, which the giant industrial group had done in 1992, was a rarity then as now.

Later in 1997, Siemens Financial Services was established and investment management became one of its six operating divisions, alongside treasury management, leasing operations and others. Lohneiss became CEO of this operation that now has more than 1,700 employees worldwide and balance sheet assets of €10bn. He describes it as a “small to medium-sized bank”.

The investment management operation now manages around €14bn is assets and has some 66 employees, of which about 30 work for SKAG, which concentrates on managing pensions assets. But SKAG is only one of the 40 plus asset managers that Siemens works with worldwide.

A decade ago, Lohneiss had a very clear vision of what needed to happen and much of his wish list, particularly for the German marketplace has gradually come to pass, but not perhaps in the way that he thought it would.

It is a winding road involving pension funds, corporate liabilities and that most German of vehicles, Spezialfonds, which are investment funds set up solely for use by usually just one institution to hold its assets. They carried special tax and accounting benefits, which have been eroded over time. One of these was that Spezialfonds issue a certificate annually stating the value of all the holdings in the fund as one single amount.

Through SKAG, Siemens pooled its securities 10 years ago within these Spezialfonds, Lohneiss explains. “This pooling had the effect of smoothening out the volatilities of the individual securities. The only thing left was the volatility of the certificate of the value of the total assets in each Spezialfond.”

That level of risk diversification was good at that time, he says. Also, there was an accounting benefit in that the valuation of the fund was done on a ‘book value’ basis. “So long as the market value was in excess of book value, and so long as this was the case, market volatility would have no impact on the value of the certificate from an accounting point of view.”

In the past 10 years, group accounting has moved from German to US GAAP and this resulted in the market value of the underlying assets having to be used. “While under US GAAP you still have the portfolio diversification benefits of asset pooling in a Spezialfond, but no longer any protection from the volatility of the overall fund given by the certificate. Book value no longer existed!”

So the group had to work hard to find a solution to this volatility. “If you did not find a solution, it would be very hard to hold a high percentage of equity, which could have a significant impact on our P&L,” says Lohneiss.

The solution came in the form of a contractual trust arrangements, that have been widely adopted under the ‘CTA’ acronym by many major German corporates. “This is a structure that is akin to a pension fund, which has the advantage that the company continues to exert full authority over the structure as its sponsor. But from a US GAAP viewpoint the CTA is off the balance sheet.” This means that volatility of the assets no longer has a direct impact on the balance sheet and P&L.

“In fact, the balance sheet would be subject to the US GAAP rules, determined by FASB, and these are related to the usual practice in the US. So if you have an underfunding situation, you have to take care of it by an amortisation period of 15 years and if your expected return is much higher than your actual return, this will have to be included in realised losses etc.”

Lohneiss believes the CTA was “a very good way of simulating a pension fund”. It was also a method of doing away with a particular problem that started with US GAAP.

“The fund as we had it up to then, was not accepted under US accounting rules. If we had continued to use the fund certificates in our corporate balance sheet, we would have had to account for each individual security and not just the funds’ certificates. That was another major disadvantage of keeping the structure as we had it.”

The CTA is still very much a viable concept in Germany, he believes. “We have seen other groups emulate what we have done.”

But things never remain static. “In the past five years in Germany, there have been major regulatory changes in the corporate pensions environment. We have many more ways of handling pensions than 10 years ago.”

The pension fund vehicle traditionally used in Germany emanates from the insurance industry. “The precursor of the new Pensionsfond vehicle is the Pensionskasse, which has the disadvantage of very conservative investment rules and strictly enforced by the regulator. So we never considered a Pensionskasse as a viable concept for us.”

He regards the advent of the Pensionsfonds in 2005, though still having insurance roots, as a real step forward because of its more liberal guidelines. ” For example, there are virtually no constraints on the proportion of equities allowed.” But it is still subject to the supervisory authority, though with a milder degree of control.

“We see the Pensionsfonds as a valid alternative to the CTA,” he says. “There is one other aspect, as to why you might prefer this to a CTA and that is cost.”

So all in all, given these different changes, there are certain still idiosyncrasies in Germany today, in his view. “If you run a CTA, you are subject to the full force of the insurance needed by law - the Pensionsversicherungsverein(PVV) and the costs of this.” The CTA does not help in this regard at all and the sponsor is in the same position as a company using the book reserve system and paying the PVV premium for covering the risk of insolvency.” This is despite the fact that it has ringfenced and dedicated assets to cover its pension liabilities.

“You obtain no recognition for the funding through the CTA,” he points out. “Under the Pensionsfonds rules, the funding is recognised and your PVV contribution is much less. This is a serious issue that anyone making this CTA- Pensionsfonds choice needs to consider. But otherwise, the impact on the sponsor is the same in terms of accounting rules.”

On the transfer of liabilities into a Pensionsfond, Lohneiss points out that you have to be careful. “The Pensionsfond has different tax implications, particularly for the beneficiary. This is why not all liabilities can be transferred to this vehicle.”

Looking back over the 10 years, he says: “Our original idea of taking pension liabilities out of the balance sheet, or at least making sure that they are separately funded was 100% correct when we started 10 years ago.” Other corporates either have taken or will be taking similar steps. “We have been a front runner here and will continue to be.”

He now sees the emphasis change from Germany to Europe. “Siemens is a global company operating from a pensions perspective in a totally fragmented environment looking regionally.” He is amazed at how difficult it is to make comparisons between countries on pensions issues, particularly on the tax side.

There have been moves, especially in Europe, to find a common platform for pension provision. He cites what Unilever, IBM and others have been doing. “Over the past three years, we have looked very seriously in Europe at potentially having a common platform, so that we could transform a German approach into a European one. This would include the UK, Switzerland and the Netherlands, where Siemens has particularly important pension plans.”

The outcome of this search is that Siemens finds it is still subject to serious impediments as far as the tax regime is concerned. “It will continue to be very difficult to change the different tax treatments, which create disadvantages.

“While there is considerable convergence where investment guidelines are concerned to set up funds on a European scale, say in Luxembourg or Ireland, it still leaves open the question of a common tax regime. In my view, it is unlikely to be easily achieved as the tax authorities do not act at a European level.”

Overall he is not optimistic about the possibility of either a European or global platform emerging. “It is difficult enough on the investment front, but even more so, if you want to include the liabilities. I am not aware of any way in which to pool liabilities across Europe!” So at the European level the finding of a common pensions solution is faced with tremendous challenges.

While in the long run, he believes these challenges can probably be overcome, what can be done more immediately? “For European and global groups, my view is that you are bound to come up with virtual schemes, in other words trying to run your business as if on a common platform.”

This will require immense organisational effort, since it is not supported by hard and fast rules, and ultimately will depend on a consensus among trustees in the different countries, he says. “But trustees are and have to be highly local”. Nonetheless Lohneiss is convinced that this is a route well worth travelling for any European or world company.

“There are opportunities to be availed of, by having common benchmarks, a defined set of asset managers, clear rules for asset allocation and a standard way of measuring risk. This is what I see happening in the foreseeable future.”

He believes that a well established operation like SKAG can continue to have a role to play, but had it been possible to have a common platform in Ireland, for example, this company could well have disappeared. “But with the preponderance of Germany within the group’s pension areas, SKAG continues to be a most efficient vehicle. But it does not stand in the way of achieving virtual communality in our pensions business.”

Another feature of the past decade has been the growing concerns about the inherent risks presented by defined benefits schemes. “But it was the coincidence of two major factors: the decline in share markets in 2000 to 2003, and the relentless fall in interest rates, that lead to huge pension scheme deficits, with asset values falling and liabilities increasing. For me and others this was a once-in-a-lifetime event, such as we had never seen before.”

This made the chief financial officers of corporates worldwide realise they had a real problem, he adds. “The reaction was to close DB plans and to move as far as possible into DC systems. But this means shifting the risk from the stronger sponsors’ hands to the weaker hands of the beneficiaries. The individual DC approach loses out from the benefits of diversification over a large number of beneficiaries and over a long number of years.”

Lohneiss understands why the flight from DB is occurring, but he is surprised at how little discussion there was outside the corporate arena as to what this transfer of risk really means. “The risk does not disappear - it is only shifted.” The burden is being moved by the corporate to the individual and from the state to the individual, he points out. “This is a highly significant development in subjecting the individual to both these forces, but has been little understood and insufficiently discussed.”

In Germany, Siemens closed its DB schemes to new entrants, who are now in a system more DC than not, he says. “It is not pure DC as a guaranteed minimum rate is provided.” This way of sharing the risk Lohneiss finds acceptable, as he does not support 100% DC systems. In 1997, Siemens was one of precursors to expanding business into serving third party clients outside the group. “This was based on the operations of SKAG and its range of Spezialfonds.”

These ambitions were hit by the decline in equity markets after 2000, making for tough conditions for an investment company to prosper as a newcomer. “Another factor was that SKAG could only offer a relatively narrow range of products. There was a premium in those days for introducing new products. Also, there were many demands coming from our internal customers, such as the CTA, the Siemens Pensions Trust.” The upshot was that the operation set up to do the external marketing through Siemens Financial Services did not acquire the market share anticipated.

“But we were not sitting on our hands. Our attention focused on a company we have had in Austria Innovest, which had superior products for the third party market. They use a multi-manager concept, selling the best performance producers they can hire and this is repackaged in fund certificates each with the benefits of diversification across various investment managers.”

For a niche player, he sees this approach as having a great advantage: “you do not have to be an investment factory to come up with new products”. This provided a way of following the market, while the in-house operation’s investment style would be developed over the years. “So in recent years, we have refocused our marketing efforts on Innovest and are selling in the third party market today in Austria and increasingly in Germany.” The public funds of SKAG will continue to be marketed and offer particular advantages, especially for Siemens employees with low costs and good performance. “This range is narrow, while Innovest’s is very broad.”

SKAG continues to play the major role in handling the investments of the CTA and the Pensionsfond. But he sees changes here over time, as those assets managed in a more passive way, for example part of an immunisation programme, are differentiated from those assets being invested actively for higher alpha. “You will also see assets being dedicated to different layers of pension liabilities. So those receiving pensions might be invested on a different basis to active members. This applies particularly where the pension schemes are closed, where over time you move closer and closer to a bond emphasis.”

Developments such as this will impact on internal credit provider and asset manager. “It would be logical to have those strategies which are closer to passive to be on an enhanced indexing basis and to be managed by the internal provider.” But external providers would be used for alpha sourcing. “You will be looking for a larger array of investment styles, which an internal manager can never master.”

Internal providers, in his view, are more akin to an investment boutique focused on an individual style or a small set of styles. “These should be complementary to using other styles from the point of view of the sponsor.”

Lohneiss is convinced that there is a big role for the internal investment manager to play as they operate at low cost once a successful style has been developed. On the development of business for third parties, he reckons the operation has been very successful in Austria, with some €3bn on this basis of the €4.5bn managed there.

SFS continues to offer consultancy and advisory services through Pensions Advisory which is a very important part of the offering, particularly because the current environment is so demanding. With the manager of manager activities, having the advisory capability is a potential way of connecting with pension customers. “We will continue with this service and hopefully emphasise it somewhat more, based on our deep knowledge of pensions issues.”

Lohneiss is optimistic that what SFS brings to the marketplace, both in its pensions business and its other activities will be successful because of the mix of in-house and external customers inherent in its approach. “The future success of SFS will depend on having a very solid captive base, plus a credible external business. It is a combination of both, which makes for a successful captive company.”