At 11:00 on a freezing morning – 2 December 2003 – Friends Provident Pension Scheme took decisive action.
The scheme implemented a landmark hedging transaction fully protecting itself against falling interest rates and rising inflation.
They were the first pension scheme to do so, and they set in train the multi-billion hedging transactions that have since become commonplace and are known generically as Liability Driven Investing or LDI.
It was the culmination of months of discussion and planning. Even so, the fledgling inflation swaps market was extremely thin coming up to Christmas and this was a very long dated and large derivatives transaction. In fact, back then, it was the largest of its type to date.
I was working alongside my favourite trader, Jon Mitchell (Merrill Lynch’s Head of Inflation), Rob Gardner (now Co-CEO at Redington) and legendary ALM guru, Philip Rose. For us, it was like landing a 747 on the Hudson.
For Friends Provident Pension Scheme, there was no precedent for a pensions-hedging transaction of this size or type and, at the time, it flew directly in the face of conventional wisdom.
Nonetheless, eight years later, the transaction has proved far more effective than any of us involved with it would have believed possible. The 30 year real yield on 2 December 2003 was 2.13%; these days it is close to 0%.
That utter collapse of the real yield (i.e. a sharp fall in interest rates AND an equally sharp rise in inflation expectations) should have cost the pension scheme around £213 million in increased liabilities; but it hasn't. Why not? Because against all the odds, it hedged that very risk.
Many much larger pension schemes still haven't hedged. In some cases that failure to take decisive action over the last eight years has added billions to the liabilities.
Why is it that some pension schemes consistently take effective, decisive action, whilst others do not?
Here are FOUR key characteristics of pension scheme trustees who DO consistently take effective, decisive action:
1. They examine the Hard Evidence and act on it – regardless of Conventional Wisdom.
The first time I presented to Paul Cooper (Friends Provident's in-house actuary) the proposal to de-risk the entire £600 million pension scheme, there were two simple numbers we discussed for over an hour. Just two numbers.
The first was the amount by which Friends Provident Pension Scheme's liabilities would increase given a micro (0.01%) fall in interest rates. That number was just over £1 million. Imagine that for a second. Interest rates move around in the traded capital markets all the time; and the tiniest of tiny moves jacked up the liabilities by a million quid!
What's more, this implied that a one percent fall in interest rates would ratchet up the pensions bill by more than £100 million. No-one was predicting a one percent decline in long term interest rates, but that wasn't the point. If it happened, the pension liabilities would rise by an insanely large amount.
The second number we discussed in meticulous detail was the amount by which the pension liabilities wouldincrease for every micro (0.01%) rise in inflation expectations. This number was also circa £1 million. Which meant that a one percent rise in inflation expectations would drive up the pensions bill by just under £100 million.
The nightmare scenario in my presentation was a world in which interest rates FELL by 1% AND inflation ROSE by 1%. The pension plan would take a combined hit of £200m!
But the chance of interest rates declining with inflation simultaneously rising was non-existent. Colonel Gaddafi had more chance of becoming the Pope. At least, that's what Conventional Wisdom said. Conventional Wisdom back in the day reasoned that if inflation rose, the Bank of England would inevitably raise interest rates to bring it back down. It would be automatic, a sure thing. Guaranteed. Newtonian physics.
A world in which interest rates could fall by 1% and inflation could simultaneously rise by 1% was the stuff of pure fantasy. This was one of the first things one learned at the LSE. To suggest otherwise, just showed you knew very little about Economics.
An hour into our discussion, Paul and I both agreed that if interest rates fell and inflation rose it would be an unmitigated disaster for the pension scheme. There were simply no equity-like assets that could offset that kind of damage. What we just could not agree on was how likely that scenario was to materialise.
So we went back to the evidence.
We were on the sixth floor of the Merrill Lynch offices in King Edward Street overlooking Paternoster Square. The table was strewn with empty coffee cups. All the water bottles were empty; fizzy and still.
", Paul said. "You have my undivided attention
." (I had written an article
for Finance Magazine saying that unhedged liabilities were the elephant in the room but, in order to be convinced, Paul demanded more evidence than I had yet presented).
I made three arguments:
Argument One: Over the previous 100 years, the real yield had been down to zero on several occasions. Indeed, the "normal" levels of 3 or 4% (and the floor of 2%) so readily quoted by Conventional Wisdom were the outliers, the exception, NOT the norm. We had experienced zero percent real yields in the past and we would likely see them again. I had 100 years of data and the 100 year graph.
Argument Two: The risk of materially lower real yields was a risk the pension scheme JUST COULD NOT AFFORD TO TAKE! If Conventional Wisdom was wrong, the entire pension scheme would be in jeopardy. And, crucially, in 2003, a hedge was relatively affordable. Why wouldn't you??
Argument Three: A new era of transparency (post Enron / Tyco / Worldcom) had ushered in sweeping changes to global regulation and accounting rules. Pension schemes were suddenly forced to mark their liabilities to market and report them as a debt, squatting like a giant toad on the sponsoring corporate's balance sheet. No exceptions.
It seemed reasonable to infer that this development would inevitably spur ALL companies to compel, at all costs, their defined benefit pension schemes to manage the volatility of the pension deficit. Which, in turn, would mean that demand for gilts and swaps (as hedging instruments) would soar. In the absence of massive increased gilt supply, the price of gilts would rise in the coming years, and would keep rising.
And if (as seemed plausible, even probable) the government decided to take the same uncompromising "mark to market" approach to its vast unfunded public sector pension liabilities, that would have an incredible impact on the price of gilts (upwards) and their yield (downwards).
That, in turn, would cause all defined benefit pension liabilities to sky rocket to infinity and beyond, since pension liabilities increase at warp speed as yields fall.
If the Land of Mordor (aka Negative Real Yields) did materialise, then failure to hedge, I argued, would prove catastrophic. Maybe not for several years, but eventually it would prove fatal.
We went over it and over it. Again and again. Paul was wrestling with the fact that no-one else shared this view, no other pension scheme had done such a transaction and last, but not least, he would need to persuade an entire board of trustees (and the Board of the corporate) of some seriously unconventional wisdom. It was a huge ask.
We had been talking for the entire afternoon. Finally, he leant back in his chair. "OK. I get it, I buy it, I'm going to make it happen."
And he did.
Paul Cooper is an intriguing guy. He's softly spoken, completely bald, highly intelligent and he has an acute sense of humour and a gift for getting to the point.
He doesn't tire of interrogating the evidence and calmly persisting until, Columbo-like, he gets a satisfactory answer. He is also an actuary with years of experience dealing with banks, asset managers, advisers and trustees. Back in 2003, he was almost uniquely qualified to guide the pension scheme through the labrynth of capital markets, derivatives and pension maths necessary to "make it happen".
2. They have advisers who think Outside the Box and understand the Big Picture
In 2003, I was an investment banker, not an adviser. This was a problem. As I pitched my apocalyptic world view of negative real yields and soaring liabilities I (mostly) met staunch resistance. Adviser after adviser argued that hedging against a falling real yield was a complete waste of time and, more importantly, money. If any hedges were to be implemented, it was to protect against falling equities, not the real yield.
But it turned out that Friends Provident were advised by Towers Perrin, a firm who were willing to be persuaded of the benefits of hedging against a falling real yield.
Mark Duke and Steve Bonner, two of Towers Perrin's leading consultants, picked up the ball and ran with it. Without them, it would never have happened. I could cite 50 pension schemes who considered hedging in that year, but simply could not get their investment consultant to sign off on the strategy. Too expensive. Misconceived. Irrelevant. Too complicated. Wrong level. And so on. In that year, I heard them all.
3. They have an effective governance structure that allows the trustee board to make key decisions and implement them rapidly
One of the fundamental flaws inherent in the board structure of the traditional pension scheme is that decisions are typically made by committee; much like a jury. This can easily lead to stalemate and paralysis.
Another, is that it meets too infrequently to allow sufficient time for proper discussion. A typical board meeting may have up to ten items on the agenda, six of which are major topics each worthy of a day's debate.
Yet another, is that The Decision often requires a level of expertise that many trustee boards do not possess. In my experience, if you don't have a couple of investment committee members who really know their capital markets kung fu, you're much less likely to be able to respond to the swirling fog and changing landscape. You might get lucky and make the right call, but that's hardly the same thing.
Going into 2012, with the level of uncertainty and market volatility we are facing, every pension plan should be ramping up the level of in-house expertise. Every trustee should be devouring daily, real-time market intel and quizzing market experts. Just as the flight crew pores over data before and during the voyage. They don't wait until they're in the ice storm 30,000 feet over the Atlantic before they come up with a game plan.
One long-serving pension trustee whom I know well, recently resigned from the board because, in his words, "I'm not the right person for this job. I don't have the skill set." That was an incredibly courageous step to take, and it was the right one.
He has now been replaced by someone with 20 years of battle hardened experience in the capital markets. Someone who has spent the last 20 years assimilating complex data and making fast decisions in fast markets. That pension scheme's governance level just rose sharply and the switch will undoubtedly save them a lot of time and money in the years to come.
4. They are never lulled into a false sense of security
Just because there are monthly board meetings doesn't mean "it's all in hand". It just means there are monthly board meetings. Unless EVERY board meeting is spent looking at current market data, analysing current pension plan data, weighing current expert opinion and taking specific pre-planned actions as a consequence, those board meetings are not much more than an alternative way to spend a Thursday in nice company.
Pension schemes that today find themselves fully hedged, owning lots of valuable gilts and well diversified growth assets aren't in that position due to blind chance. They didn't just get lucky. They did the difficult maths, counted the number of days left before the scheme starts to eat itself, fired some managers, hired others, scenario-stressed their assets and liabilities, looked at the PV01 mismatch between their assets and liabilities, calculated their negative convexity and risk, asked their consultant hard questions, assumed there would be an ice-storm and then took decisive, rapid action.
The Take Away
Pension plans that have not hedged are now in a very difficult place. In these market conditions, there are very few choices and no luxuries. But for some, it's not too late. There are hard decisions to be made in the short time remaining.
For example, there is a valuable illiquidity premium to be achieved from certain asset classes and there is still a disciplined hedging program to be implemented (YES!) even at these levels. The iceberg looms large against the night sky, but implementing the principles above may help avoid a full-on collision.
Maybe. I read in Financial News
that several hedge funds are starting to short those companies whose pension plans have not hedged. The killer predators have done the maths (it's not hard) and worked out that, for some, it is already too late. The deficit contributions bill that will be presented to the corporate sponsor some time in the next 12 to 24 months is likely to be so large, it will ultimately wipe out the entire corporate group…
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]