Don't stop thinking about tomorrow

One of the lessons of the credit crunch is that long-term outcomes can be distorted by short-term rewards. This lesson extends beyond sub-prime loans to pension buyouts, whereby an insurance company is paid to take on someone else’s pension commitments.

For now, buyouts are off the agenda. Plugging the holes caused by falling equity values has pushed them beyond the reach of most pension scheme providers. But if they are down, buyouts are far from out. When markets revive, many employers and trustees will once again start looking at ways to offload their retirement schemes.

Why this disaffection with pensions? The onerous nature and short-term focus of regulation and accounting rules make it attractive for pension schemes to replace equities with bonds. This may fix the immediate problem, but it doesn’t address the fact that pensions are long-term obligations, and over the long term equities have proved a better investment than bonds.

Faced with these often irreconcilable demands, many pension sponsors and trustees simply want to hand the problem over to someone else. A buyout is the perfect answer. After all, managing risk is what insurance companies are about, so they should be able to handle pension risks better than most. Furthermore, their capital is regulated specifically to take the strain of that risk. And, if things go badly wrong, the UK insurance industry’s Financial Services Compensation Scheme (FSCS) is a more comprehensive safety net than the pension industry’s Pension Protection Fund (PPF).

We believe many of the benefits of buyouts may be illusory. Take the management of risk. While historically many more company pension schemes have collapsed than insurance companies, insurance companies have often failed to meet policy holders’ long-term expectations. The total assets involved in various insurance debacles ranging from endowments, through pensions mis-selling and Equitable Life to zombie funds top £200 billion.

Capital adequacy complicates the picture further. Imagine a massive bulk buyout involving the pension scheme of every FTSE 100 company. We calculate that transferring such a large chunk of the UK’s private sector pension obligations would cost in excess of £400 billion. The total liabilities thus taken on would represent more than ten times the additional security of £40 billion that would be required of the buyer by the regulator to approve such a deal.

This is leverage by any other name and, as we are all now painfully aware, leverage spells trouble tomorrow if the buyer miscalculates the risks or the costs. Of course, if one insurer has miscalculated it’s likely to come at a time when other insurers have made similar miscalculations. This is how a problem becomes systemic.

Now contrast that with leaving the pension assets where they are, backed by the combined and highly diversified market capital of around £1 trillion that still stands behind the UK’s 100 largest companies. We think it is clear where the nation’s private pension assets might be safer, at least in aggregate.

And what of the FSCS? True, it nominally underwrites 90 per cent of an insured’s losses, against an average of just 60 per cent for the PPF. But it has recently only been raising around £120 million on average in annual levies and has a limited pool of industry participants on which to call for more. As a safety net, it remains untested.

While the market turmoil has pushed issues such as these onto the back burner, we don’t believe that is where they will stay once markets pick up. At that stage, those involved with handling pension fund risks may want to remember the hard lessons of the credit crunch.

To return to where we started, perhaps the most important lesson concerns the problems that arise from misaligned interests. Sometimes the immediate incentives for those putting together pension buyout deals encourage them to get the business quickly rather than to price it correctly. Rapid growth is likely to be more speedily rewarded than long-term profitability. It is easy to see how the interests of the managers of the insurance company may be shorter in term than those of the pension fund.

We are not saying that buyouts are simply a dangerous diversion. They make sense for small pension schemes and schemes with weak sponsors. These will benefit from the diversification of mortality risk provided by being pooled with other schemes and the extra protection given by the insurer’s capital.

But larger schemes of stronger employers may find that salvation lies closer to home. The covenant strength and diversification provided by their own sponsoring business may turn out to be superior to anything a buyout provider can offer. In these circumstances, we believe they may be better off keeping their pensions, but using more sophisticated solutions for their management. These could include transferring some of the risk to participants by offering a well-designed DC scheme; more closely matching assets with eventual liabilities by using bonds and derivatives to reduce balance sheet volatility; and/ laying off risk in the capital markets by purchasing annuities or other guarantees.

The key with all these solutions is that they are likely to be more closely tailored to the risks faced by the fund, rather than those of the buyout provider. As a result, they are likely to end up being cheaper, more flexible and, just possibly, safer.

Patrick Rudden is Head of Blend Stategies and David Hutchins is Head of UK Research and Investment Design at AllianceBernstein. Patrick Rudden gave a lecture on pension buyouts to Oxford MSc in Financial Economics students in March 2009 as part of the MFE Senior Practitioner series.

[This article has been reproduced with permission from Said Business School, University of Oxford. The article originally appeared in the School e-magazine, THEWORLD@OxfordSaid. http://www.sbs.ox.ac.uk]