Thursday, March 11, 2010

Return of the Pension Fund Fudge?

Tony Tassell of the FT reports on the return of the pension fund fudge:

In the Hitchhiker’s Guide to the Universe series, the character Zaphod Beeblebrox wore a nifty pair of “Joo Janta 200 Super-Chromatic Peril Sensitive Sunglasses”, which had been specially designed to help people develop a relaxed attitude to danger. At the first hint of trouble they turned totally black, preventing the wearer from seeing anything that might alarm.

The UK pension industry now seems to want to adopt the accounting equivalent. The National Association of Pension Funds has called for an overhaul of accounting rules that govern the disclosure of company retirement liabilities, arguing that these are intellectually flawed and partly to blame for the widespread closure of schemes.

The move is hugely significant, not only for the UK but around the globe. The UK led the big revolution in pension fund accounting over the past 10 years to value assets and liabilities of a scheme at a snapshot of current market values.

The shift under the controversial FRS 17 accounting standard away from a system of fudging valuations by “smoothing” out market swings led to a fundamental change in the relationship between companies and their pension funds.

Amid the volatile stock market conditions of the noughties, it brought home to companies the real risks they were taking with so-called defined benefit pension funds — schemes where the retirement income of members is based on a fraction of annual salary that increases with length of service.

The knock-on effects were far-reaching, triggering the closure of hundreds of so-called defined benefit pension schemes as companies sought to stem their losses. It also led to changes in asset allocation, with funds slashing exposure to equities to invest in bonds that matched their liabilities.

The closure of schemes might have been have been painful for their members but in many cases it was inevitable given the scale of risk taken by companies. For some companies, the size of their pension fund dwarfed their market capitalisation. It was once reputed that the pension fund of British Airways, at one of the low points of the carrier on the stock market, could have bought every share in the airline and still stayed within its guidelines of not putting 10 per cent of its funds into any single investment.

And the shift in asset allocation towards bonds sharply reduced the risk that pension funds fall short of assets to meet their promises to members.

But now the NAPF wants to turn back the tide in an extraordinary reversal.

“Current accounting standards have been very damaging to defined benefit provision, leading many companies to close their schemes. Pension funds are long term institutions but today’s accounting standards fail to reflect this,” said Lindsay Tomlinson, chairman of the NAPF and a veteran fund management executive at Barclays Global Investors, now consumed by BlackRock.

This is a feeble excuse. Pension funds might be long-term institutions but long-term is not necessarily less risky. Just look at equities which have basically done nothing for a decade after all their swings. Any fund that assumed a positive long-term return from equities at the height of the dotcom boom would now be in deep problems, as many funds are.

Mr Tomlinson also offered another justification, by arguing the underlying assumption of valuing assets and liabilities to market is that markets are efficient in setting prices.

“What I say is that we all know the efficient market hypothesis is a flawed hypothesis and it is being talked about in the banking world, too,” he said.

Well that is slightly curious coming from an executive who has spent a career in the index-tracking fund management industry. This is business is based on the idea that active fund management is flawed as markets are largely efficient and it is difficult to beat them after taking into account costs.

And if markets are inefficient that only highlights the risks of assuming some kind of long-term returns to minimise an estimate of current liabilities.

What kind of fudge does the NAPF think should be employed? Or should investors in companies and members of pension fund just don the Zaphod Beeblebrox sunglasses and ignore the risks?

Interestingly, the push to overhaul accounting rules comes at a time when European private equity is suffering from a dramatic drop in pension fund commitments:

Pension funds’ “dramatic drop” in investing in private equity saw European fundraising collapse to €13bn last year, according to the European Private Equity and Venture Capital Association in its annual research. This amounts to 75% of the total amount raised by just two funds the year before. It also compares to the 84.2% drop in wider fundraising.

Pension funds have also been large investors in the asset class through funds of funds, and concerns about their underlying investor base meant these collective investment vehicles also cut their commitments to private equity by 88%, EVCA said.

As a result, banks became the largest investor group in the 184 funds that made an initial or final close, despite the turmoil in the banking industry.

As revealed by Financial News, at the start of the month, pension schemes around the world made far fewer investments in private equity last year, with Towers Watson, one of the world’s largest investment consultants, conducting 70% fewer manager searches for private equity funds on their clients’ behalf than in 2008. And the problem could worsen as the UK’s National Association of Pension Funds’ annual investment meeting this week is not discussing private equity.

However, yesterday, the Pension Protection Fund, which manages £4bn of assets, said it plans to make its first investments in private equity and infrastructure.

The fundraising problems and economic upheaval meant many private equity firms concentrated on their existing portfolio companies rather than striking totally new deals. EVCA said its preliminary data showed €21bn was invested last year into 4,188 European companies but 56% of this was follow-on investments to existing holdings.

Write-offs from failed companies increased to €3.2bn from €870m in 2008, EVCA said based off data from Perep Analytics.

Javier Echarri, EVCA secretary general, said: “Private equity and venture capital firms spent 2009 ensuring their European portfolio companies could weather the economic storm and march out of recession in fighting spirit.

"However private equity firms face pressures from both ends of the investment chain as institutional investors struggle to make fresh commitments to new fundraisings. The industry is therefore taking some strain, on the one hand to support Europe’s businesses patiently while, on the other hand, waiting for the exit and fundraising cycle to re-engage.

“Even so, in the depths of macro-economic uncertainties not seen for generations, private equity and venture capital firms financed around 2,000 seed and start-up companies, and as many companies again across the core of Europe’s middle-market. Meanwhile, the increase in write-offs, albeit from a low base, shows the seriousness of the wider economic situation.”

However, EVCA said its performance figures, using data from Thomson Reuters, showed private equity returned 3.1% last year while the five-year figures were 6.1% against 0.7% for the Morgan Stanley Euro Equity index and 6.8% for the HSBC Small Company index.

So the Pension Protection Fund (PPF) - the pensions lifeboat - is now looking closer at private equity and infrastructure to "improve returns", just like the US Pension Benefit Guaranty Corporation (PBGC). To be fair, the PPF still maintains a "low risk approach to investments" with at least 65% of its portfolio remaining invested in cash and bonds.

But there is a whole lot of pension fund fudging going on in the industry. Global pension funds are shunning private equity - with good reason - and now UK pension funds want to revert back to old accounting rules in a feeble attempt to shore up these investments.

Why don't we just ignore the risks of these investments and value them on a mark-to-myth basis once every 10 years? Anyone out there believe in the private equity fairy tales?

***More on Accounting Gimmickery***

The NYT published an article on Thursday, Report Details How Lehman Hid Its Woes. Hint: it's not just Lehman that hid its woes.

On a separate note, I spoke with a buddy of mine running an infrastructure project. He told me that post-Enron, auditors became way too conservative and he finds FRS 17 a real nightmare. "If I do what my auditors wants me to do, it will wipe out all our profits!". I think the accounting standards have to strike a balance using common sense rules and not be overly zealous to the point of damaging companies.

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