As the dust settles...

After the financial markets' rocky ride, Graham Buck asks how pension funds can recover?

As investors might well be warned: 'The value of shares can plunge as well as fall'. Global equity markets were already on a steady retreat from their mid-2007 peak, but the intensification of the financial crisis in mid-September dramatically accelerated the trend.

The downturn has been sharper and more sudden than all but the most pessimistic had expected, with major implications for pension funds across Europe. Even those funds that diversified to lessen their reliance on equities haven't escaped, with sectors including property sharing in the pain.

"Almost all pension funds have suffered since the summer as their investment strategies have felt the impact, bar government bonds and swaps," says Robert Hayes, head of strategic advice services at BlackRock. "Commodities, real estate and hedge funds have all performed poorly, so all funds have seen sharp falls in their funding levels.

"One crumb of comfort is that where funds base the valuation of their liabilities on corporate bond interest rates, these have provided some offsetting gains."

Indeed, cash and UK government gilts have distinguished themselves as the only major classes to escape relatively unscathed. Cash has provided positive returns with the likes of HBOS offering 5%-plus.

The effects of the crunch can be summarised under two main categories, suggests Ritesh Bamania, head of asset liability investment solutions UK and John Harrison, head of UK institutional advisory solutions at UBS Global Asset Management.

First are the uncertain and volatile funding ratios, such as:
– Significant reductions in the value of assets for many pension funds, which typically invest 50%-60% of funds in equities;

– The value of the liabilities has seen varying impacts depending on the method used to calculate the discount rate. Funds using corporate bond yields to set their discount rate experienced sharp reductions in their liability value due to corresponding rises in these yields, whereas funds using government bond yields as their discount rate saw increased liability values whenever gilt yields fell;

– While overall impact on funding ratios has varied, there has been a high variation in deficits and problems in corporate budgeting for pension costs and contributions;

– Growing deficits have raised the spectre of some sponsors becoming unable to pay.

Second are the swaps and counterparty issues:
– The collapse of some major financial institutions raised concerns over some swap positions held by pension funds. These focused particularly on the amount and quality of the collateral held;

– Trustees and their advisors had to act quickly to replace lost swap positions. The period between losing the old positions and putting in place a new swap strategy exposed funds to significant market risks in a very volatile environment;

– Negative spreads in the swaps market underlined the heavy cost of re-establishing these strategies – and the need for a clear plan on the tactical versus the strategic implementation of risk reduction.

As Towers Perrin observes, a handful of funds protected themselves by de-risking their assets and liabilities over the years. They did so through improved governance practices; increasing the understanding of pension issues of both their corporate officers and trustees; employing hedging strategies to maintain funding positions; shrinking liabilities through buyouts or member transfers; utilising trigger systems to de-risk investment strategies under the right market conditions and asset strategies to better protect against interest rate movements.

No such luck for the majority of funds though, which are still heavily weighted towards equities and whose trustees have seen funding levels deteriorate sharply.

A typical global equity fund had already experienced a decline of 15%-20% in the year to September 2008, but in October alone suffered a further fall of 10% -12%.

While UK funds have made moves over the past decade towards diversifying their holdings into alternative classes such as hedge funds, private equity and corporate funds, their weighting in equities is still typically 50%-60%.

By contrast, for pension funds in countries such as Germany and the Netherlands the figure is
nearer 30% to 40% says Martin West, director of actuarial and investment services at Gissings. These funds have a much higher weighting in corporate bonds and gilts, and were less affected by falling markets.

So should UK firms revisit their investment strategy? Recent market volatility means that as the FTSE indices have headed back to levels previously explored five years ago, most pension funds have followed.

This adherence to equities proved no bad thing from 2003 to 2007, when global markets moved steadily upwards, says Joe McDonnell, head of global portfolio solutions EMEA at Morgan Stanley Investment Management.

"However, we're now looking at very different economic circumstances. The past year has seen low growth and high inflation, while the year ahead will be marked by low growth and low inflation.

"A rally in such an environment looks unlikely, meaning much asset allocation is in a class that's set to continue performing poorly."

McDonnell adds that his own firm sees little evidence of any catalyst to improve the situation over the short term. However, provided that monetary and fiscal policymakers continue working well together, a recovery is likely to get underway in the latter part of 2009 although "there won't be any quick fix."

West is slightly more upbeat. "I'm an optimist. My own view is that there will be a fairly strong bounce back as interest rates fall," he says.

"By this time next year, we should be in a position where the markets can begin to recover."
The impact of the credit crunch has been particularly heavy in the UK, reflecting its higher level of defined benefit schemes and an elaborate regulatory scheme.

Its effects on the value and type of investments held by UK schemes could mean that trustees will seek to increase the contributions currently payable by employers, says Mark Catchpole, a partner of Stephenson Harwood.

When the cash flow is limited, this will apply further pressure on employers, as well as having a wider impact on the general economy.

"However, the Pensions Regulator said recently that as pension schemes represent medium to long-term obligations, trustees shouldn't necessarily go cap in hand to the employer and ask for more money to make good the funding deterioration," he says. "Instead, they should perhaps allow them an extended period in which to rectify the position."

So far, trustees have generally shown willingness to concede, aware that pushing too aggressively for a cash injection also risks moving the company to the brink of insolvency and tipping the fund into the Pension Protection Fund.

What else can trustees do in the wake of the recent fallout? Suggestions from Towers Perrin comprise something of a damage limitation exercise, but include:

– Review projections of where the year-end accounting numbers might be and consider the options to help mitigate the bad news;
– Consider how pension trustees might respond and the implications of any funding agreements. It might be necessary to make a case for paying in less than they expect.
– If it is decided to protect the company going forward, work out what de-risking can be afforded now and what further de-risking might be implemented, if and when the pension plan's finances improve.

And there are a few signs of better news, adds Hayes. For example, the relative level of inflation built into index-linked bonds has slid and is now below 2% in Europe.

Morgan Stanley's McDonnell also believes that UK funds must revise their governance structures, so their investment strategy is more flexible and can respond more quickly.

"Some of the current opportunities in the credit markets are very attractive, and also offer a far more stable portfolio," he says.

"There are good distressed opportunities at present – in recent weeks the senior loans market has looked very cheap indeed. But most UK pension funds are unable to benefit. In their present form, they aren't set up to move into that space and are far too slow to respond.

Written by Graham Buck