Tuesday, December 9, 2008

Can LDI Strategies Contain Pension Deficits?

Stocks tumbled today after a 2-day rally:
Wall Street turned cautious Tuesday after a two-day rally as disturbing corporate news reminded investors of the magnitude of the economy's troubles. Stocks tumbled while demand for the safety of government debt surged.

Although the market was down sharply, the pullback was uneven, showing that investors are uneasy but also very selective. The Dow Jones industrials fell 243 points, or 2.72 percent, but the Nasdaq composite index fell a more moderate 1.55 percent as investors decided to buy some hard-hit technology names.

Meanwhile, demand for the safety of Treasury bills spiked so high that investors were willing to earn no return at all on investments bought at a Treasury Department auction. Interest rates on four-week Treasury bills slid to zero from 0.04 percent in an auction just a week earlier.

"The markets are just expressing a tremendous amount of ambivalence about the future," said Marian Kessler, co-portfolio manager of the Becker Value Equity Fund in Portland, Ore. "The market is grappling with what is certainly going to be a fairly deep recession in 2009."

To be sure, recent trading has indicated that big institutional investors are hedging their bets and putting money on both sides of the market. They have been looking for signs of recovery in a stock market that is down 43 percent from its October 2007 peak but are also keeping a hand in cash and bonds in case a run-up in stocks since last month gives way.

Despite Tuesday's drop on Wall Street, there is budding optimism about stocks simply because of the more orderly trading that has emerged since mid-November. Some observers speculate that the market is slowly forming a bottom, but the drumbeat of poor economic news makes it unlikely that the market's overall volatility is waning.

Investors are worried that companies' difficulties could make an economic turnaround harder. FedEx, a barometer of the U.S. economy, cut its forecast for fiscal 2009 earnings and capital spending as the slumping economy eroded package deliveries. Meanwhile, Danaher Corp., which manufactures bar code readers and Sears' Craftsman tools, reduced its fourth-quarter profit forecast and announced plans to cut 1,700 jobs.

The stock market's retreat wasn't a surprise given the steep advance of the past two sessions. But the reasons for the selling weren't simply based on two days of gains, analysts said. Wall Street is still trying to determine how badly companies' woes will dent profits and how soon President-elect Barack Obama's plan to introduce a flood of public works spending could aid the economy.

The Dow Jones industrial average fell 242.85, or 2.72 percent, to 8,691.33 after logging a gain 560 points over Friday and Monday.

Broader stock indicators also declined. The Standard & Poor's 500 index fell 21.03, or 2.31 percent, to 888.67. The Nasdaq composite index fell 24.40, or 1.55 percent, to 1,547.34.

The Russell 2000 index of smaller companies fell 15.67, or 3.26 percent, to 465.71.

Declining issues outnumbered advancers by more than 2 to 1 on the New York Stock Exchange, where consolidated volume came to 5.57 billion shares compared with 6.42 billion shares traded Monday.

The market's run since last month has led to some hopes that stocks might be carving out a sustainable recovery. Since reaching multiyear trading lows on Nov. 20, the Dow has risen 15 percent and the broader Standard & Poor's 500 index has risen 18.1 percent, while the Nasdaq is up 17.6 percent, even with Tuesday's decline.

Bond prices rose after the Treasury auction and as stocks fell. The yield on the benchmark 10-year Treasury note, which moves opposite its price, fell to 2.65 percent from 2.74 percent late Monday. The yield on the three-month T-bill, considered one of the safest investments, rose to 0.03 percent, from 0.01 percent late Monday. Still, the low yields indicate a high degree of investor unease.

My take on this stock market is that it will continue to grind higher and in the short-run, you should buy the dips. I agree with those that think this bear market rally has legs.

Let me show you what I mean. I typically look at the 5-day chart of the Dow. You see that gap up on Monday? Whenever you see these explosive gaps, stocks typically come back to "fill them" and then move up again. This is "normal" trading activity.

Tonight we got late breaking news that the Bush Administration has agreed on outlines of an auto bailout bill:

The legislation would include specific protections for taxpayer money, including the appointment of a so-called car czar who could force the companies into Chapter 11 bankruptcy if the companies don’t come up with their own plan by the deadline of March 31, according to the official, who briefed reporters on the condition of anonymity.

The car czar has until that date to negotiate with the companies and stakeholders to come up with a plan that satisfies the definition of long-term viability as set out in the legislation. The czar, who would be appointed by President George W. Bush, is required to call the loan if they haven’t come up with a plan by the deadline.

The administration will consult with representatives of President-elect Barack Obama on the appointment.

A far more pressing issue is to deal with the ballooning pension deficits that are going to choke public finances in the coming decade. A "pension czar" might not be such a bad idea right now.

Today we learned that the collective deficit of the UK's final salary pension schemes has shot up by 40 percent in the past month. We also learned that the funding status of U.S. pensions plans declined over 13 percent:

Falling Interest Rates Drive Pension Plan Liabilities Up 10.2 Percentage Points

Funding ratios at the typical U.S. corporate pension plan fell 13.4 percentage points in November, the worst monthly performance since the stock market crash of 1987, as declining interest rates sent liabilities soaring by 10.2 percentage points, according to BNY Mellon Asset Management.

Asset returns in a moderate risk portfolio (60 percent equities, 40 percent bonds) lost an additional 3.2 percentage points as global equity markets continued their decline. For the year to date, funding ratios for typical plans have declined nearly 20 percentage points.

"Pension plans have seen their equity investments fall by more than 40 percent over the course of the year," said Peter Austin, executive director of BNY Mellon Pension Services. "Now in November, the drop in high-grade corporate yields has produced a steep increase in liability values."

"We remain very concerned about the impact of narrowing corporate spreads on pension plan funding," Austin noted. "

The increase in liabilities in November was caused by a shift in the corporate yield curve, not a narrowing of corporate spreads, which remain at all-time highs. When corporate spreads narrow, there is a strong likelihood that plan liabilities will increase.

Plan sponsors need to be aware of the specific risks that a narrowing of spreads creates for their plan. The good news is that many of these risks can be managed through liability driven investing and other strategies."
But liability-driven investing carries its own set of risks. The collapse of Lehmans brings a new danger to pension funds: the risk that counterparties in swap deals could go under overnight.

This is why pension funds are now looking for a safer way to do liability-driven investment:

It was the collapse of Lehman Brothers that really changed things. Up to that point, company pension schemes had experienced turbulence from the credit crunch, but the demise of this one Wall Street institution flung them into the path of a force-ten gale.

Suddenly, the prevailing wisdom that pension funds should attempt to manage their inflation and interest rate risk with swaps no longer looked such a great idea if their counterparties could go bankrupt overnight.

This sudden rise in swap counterparty risk is just one of a host of issues that finance directors and pension trustees have had to grapple with in recent months. Recessionary fears have crystallised and equity markets around the world have tumbled. Supposedly uncorrelated asset classes such as private equity and hedge funds saw their valuations plummet. And volatility has shot through the roof.

Many FDs must feel like they have fallen down Lewis Carroll’s rabbit hole and are now in Wonderland where it is the norm to believe six impossible things before breakfast. But even in such volatile and unpredictable times, there are a few opportunities to be found.

Pension consultants and investment managers acknowledge that the collapse of Lehmans has not only focused minds on the risk of the swap counterparty, heightening concerns that their interest rate insurance could disappear in a puff of blue smoke. It also calls into question the viability of a so-called liability-driven investment (LDI) strategy.

But the sudden collapse in interest rates underlines exactly why it is so important to try to manage a pension scheme’s interest rate risk. As Nick Evans, principal consultant in investment advisory at KPMG, puts it: “This is not the death of LDI.” It is still possible, he says, to use swaps to give protection from interest rate movements and manage the counterparty risk.

“We are still seeing a lot of pension funds going down the LDI route,” says Mike O’Brien, head of European distribution for Barclays Global Investors. “But they are now setting more demanding terms. Swap positions are now being collateralised on a daily basis rather than weekly or monthly.

That collateral also needs to be of high quality; only government debt is really acceptable.” This ensures that if the counterparty fails then the pension scheme has cash readily to hand to set up another swap with another counterparty.

This is not the only way that pension schemes can get some protection, as KPMG’s Evans explains: “LDI means different things to different people. You don’t have to use swaps to implement an LDI strategy; you can also use physical bonds.”

Evans believes it makes a lot of sense for pension schemes to switch out of swaps and into bonds. “One of the distortions of the current market environment is that there is better yield on government bonds than there is on swaps,” he says. “And there is no counterparty risk.”

Another distortion that has arisen from the global financial crisis has come to the aid of the FD as he stares down the barrel of the annual reporting season: the yield on AA-rated corporate bonds. Plunging asset values from equities to hedge funds means there will be a sea of red on the asset side of the balance sheet when annual reports hit investors’ desks at the start of next year. Things, however, are looking brighter on the liabilities side. This is because accounting standards currently stipulate that a company uses an AA corporate loan rate as the discount factor to value its future liabilities.

The credit crunch has seen the spread of AA corporate bond yields relative to government bonds widen to historical highs. “What that means is that a higher discount rate is being used to value the liabilities side of the balance sheet so the value of the liabilities has fallen,” explains O’Brien. “This has given finance directors a bit of wiggle room. Yes, pensions deficits have got worse, but it’s not as bad as it could have been,” he adds.

But there’s no room for complacency, warns Robert Hayes, head of BlackRock’s strategic advice services team. “This presents a big potential risk. We cannot assume that the valuations of different asset classes will continue to move in the same direction. If corporate spreads correct before the equity market recovers, then the pension deficit will widen further,” explains Hayes. “Both pension trustees and FDs need to be very aware of potential risks and do what they can to minimise them.”

Increasing the proportion of assets invested in corporate bonds would help pension schemes to manage this risk as this would help to align the movement in both the asset and liability side of the balance sheet, says Hayes.

Investment managers and pension consultants are unanimous that buying corporate bonds makes sound investment sense as well as being a good way to protect against narrowing of spreads relative to government bonds.

“AA corporate bonds currently have a spread of nearly 300 basis points above government bonds. That represents a default risk of 23%, or an assumption that nearly one-quarter of companies will default. The worst over a ten-year period has been less than 10%,” says Hayes.

The current yield gap between AA corporate bonds and government bonds reflects the lack of market liquidity rather than an accurate reflection of corporate default risk, says Hayes.

As pension funds invest over the long term, they can afford to invest in a more illiquid asset class. KPMG’s Evans agrees: “A pension fund is a long-term investor that does not need to sell its bonds next week, next month or next year. The pension fund can afford this illiquidity premium especially for assets that will give good returns at an acceptable level of risk.”

The use of AA-rated corporate bonds to value the liabilities from an accountancy perspective has helped the FD when it comes to facing investors, but there are problems when it comes to dealing with the pension trustees.

The accountancy rules stipulate that a company uses AA corporate bond yields to value its liabilities (though that is currently being reviewed by the standard setters), pension trustees are required to use the government bond rate. This has fallen dramatically as interest rates around the world have been slashed and the tumbling value of assets like equities mean that pension trustees see their deficits ballooning.

“Up until now, the relationship between government and AA corporate bonds has held quite steady,” says Evans. “But that has now changed and creates a potential conflict between FDs and pension trustees.” From the trustee perspective, the pension deficit is much larger than from the FD perspective.

Moreover, while the company is required to close the pension deficit over a ten-year period, trustees like to narrow the gap as quickly as possible, explains Evans. Falling interest rates and lower investment returns mean that trustees believe the only way to remedy this situation is to ask FDs for more lumps of cash to put into the pension fund.

But the crisis in liquidity and the arrival of recession means FDs are trying to preserve as much cash as possible to protect the future of the underlying business and are extremely reluctant to put any additional funds into the pension scheme.

While there are still options open to companies to manage their liabilities, the asset side of the equation is trickier. The current volatility in all financial markets makes it incredibly difficult to devise an investment strategy that will satisfy the claims on the fund.

Kevin McLaughlin, senior investment consultant at Mercer’s financial strategy group, says, “Some of those schemes that had a large proportion of their assets invested in equities decided to protect against any downside using options.”

As equity volatility is still so high, schemes could get good value by selling call options and using this to fund downside protection. In effect, they are giving up the chance of some upside in return for some downside protection.

Many pension funds have seen the value of their equity portfolio plummet and they are reluctant to sell their equities as that would crystallise the losses. “Over a five to 10-year view, they expect the value of equities to rebound quite strongly. I think that’s the right view,” says Evans.

Before the credit crunch took hold, many pension schemes were in the process of trying to reduce the risk of their portfolios while maximising their returns. They did this by investing in alternative assets such as private equity and hedge funds. But both fund managers in both those asset classes were avid users of debt, which helped them to amplify their returns, but now makes life a lot more difficult.

Private equity deals have to come to a halt and hedge funds are going through an exceptionally tough time. Many hedge funds that geared up to exploit the mispricing of two assets have, in recent months, seen a large number of those bets not work out.

Not only have hedge funds had to pay back the debts by selling off their assets ­ almost invariably much depleted in value ­ they are now also seeing a significant number of investors getting cold feet, queuing up to redeem their funds and putting yet more pressure on hedge funds to sell even more assets.

The level of uncertainty surrounding the alternative asset universe means most pension schemes will have to put these schemes on hold. As McLaughlin says, “It’s going to be very difficult at the moment to put more money into various alternative asset classes, particularly given the immense difficulty that hedge funds are facing.

This industry needs to work through the difficult issues first. Similar problems may face the private equity industry as deleveraging continues.”

McLaughlin says that pension schemes have limited options available to them to prevent further devaluation of their asset portfolio. “It’s extremely difficult because many asset classes have been highly correlated in the recent downturn and all have seen their valuations move downwards together, with the exception of government bonds. The only real choices available are to invest in corporate bonds or to take some risk out of the equity portfolio by using options.”

Hayes says that both FDs and pension trustees need to ensure they remain open to new possibilities as they arise: “They must ensure that their operations are flexible enough to take advantage of any investment opportunities.”

The jury is still out on whether or not liability-driven investing will help contain soaring pension deficits over the next decade.

However, the present disaster course is clearly not acceptable. It is mind-boggling to see pension consultants recommending no major investment strategy changes for Florida’s public employee pension plan although it has lost billions in the financial market meltdown.

These consultants are still living in the past, peddling dangerous advice. They are about to get a rude awakening in 2009, but ultimately it's taxpayers who will pay the price for their mindless wisdom.

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