Safe haven: Lehmans downfall changes the face of liability-driven investment

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.

Stash the cash
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.”