Over the past two years investment banks have been drawn closer to the warm glow of pension deficits and the sparking apoplectic panic of corporate finance directors examining their books under the pressure of FRS 17, among other factors.
Not only are UK pension funds recognising that their liabilities stand somewhere around £1000bn (€826.2bn), but the sponsoring companies are realising that their own valuations are being adversely affected by the new accounting rules, which require pension liabilities to be on the company balance sheet and restricts valuing investments with a long-term view.
With a heightened awareness of risk and having watched hedge funds make money while their portfolios only reduced in value, pension fund trustees became open to suggestions. Increasingly, it has been the investment banks which have been whispering ideas – think derivatives, think credit markets, think risk, think of us often under the guise of liability driven investment (LDI).
As LDI has become the new financial jargon for trustees, the asset managers have been busy acquiring or expanding their knowledge of credit products and derivatives.
Estimating how much this business can be worth to these keen new players is impossible, if only because of the law of Omerta has yet to be broken within the investment banking world. In part it is also because how it will develop and how pension consultants and asset managers will respond, is yet to be seen.
But you certainly know business is ‘robust’, as the bankers like to say, when several of the biggest players in the sector feel unable to talk about business because top people are on the move.
The rush to move
In the past two months Kevin Rush, head of the European Life and Pensions Advisory Group at Credit Suisse First Boston, has left and long-serving Alan Rubenstein, head of Morgan Stanley’s European pensions group, moved to Lehman Brothers to launch a new pensions business. At Merrill Lynch, head of its pensions and insurance group, Dawid Konotey-Ahulu, has moved onto pastures new and while no replacement has been named, Gareth Derbyshire has joined Merrill recently from Morgan Stanley. ABN Amro’s head of actuarial work, Francis Fernandes has left, having been poached from Lane Clark and Peacock.
“There's no doubt about it, the investment banks are increasingly looking to eat the asset managers lunch,” says James Bevan, chief investment officer at Abbey. “I see an increased interest in not only structured products but liability-driven investment, portable alpha and transitioning.”
There is little argument that the big boys have moved outside their more removed roles. “There's a mixed market in Europe, in some cases more insurance companies are dealing with them, in others pensions. The impact on asset management firms is yet to be felt,” warns Rodger Smith, managing director of research company Greenwich Associates.
While Goldman Sachs and Morgan Stanley were first out of the stalls to set up pensions and insurance groups, primarily to chase the equity transition, the last two years have seen a spate of new arrivals. These pensions and insurance groups are leveraging their own banks’ expertise in credit, structured products and risk analysis and if their loyalties are to be hinted at, it is no co-incidence they sit close to their derivatives and trading teams.
“From a European perspective there was a lot of action in the Danish market in 2001-2002 with pension funds put into hedging strategies,” explains Keith Jecks, global head of pensions advisory at ABN Amro. Around the same time UK insurance companies sought to de-risk and investment banks saw new opportunities.
As insurance companies faced problems with their policy liabilities, this more strictly regulated market was forced to address the situation with the help of investment banks and their expertise in risk. The solution was a constant-proportion portfolio insurance (CPPI) strategy, a ready-wrapped derivative product that as market risk increased, decreased risk to insurance firms. As a result equity holdings fell from 75 per cent in 2000 to about 30 per cent today.
It is argued that current equity levels of 63 per cent in UK pension funds will also fail to re-balance liabilities and hedge risk. Today the Dutch and UK pension funds markets are the most active. According to Mr Jecks, UK pensions will be looking at shifting £400bn out of equities into forms of fixed income investment of which he believes £200bn will be using hedging overlay strategies.
To combat greater regulatory pressure, under-funded portfolios sought out a strategy to manage liabilities and remove deficits. They also wanted to remove risk, at least unrewarded risk such as interest rates and inflation.
“In reality investment banks have always served pension funds, but were one or two steps removed due to the presence of intermediaries such as fund managers. The market downturn, coupled with regulatory change in the early years of this decade, created room for others to sit around the advisory table and pension funds were disillusioned with past advisers,” says Niall Quinn, business development director at Gartmore Investment Managers and formerly with Goldman Sachs.
Not only that, but the trend to LDI required the sort of products that investment banks were so good at designing: structured derivative solutions.
There has been another reason. “Pensions have gone from being a HR issue to a corporate finance issue,” observes Mr Jecks. As the new accounting regulations brought the pension fund to the company bottom-line, finance directors have finally got involved and their experience is in dealing with investment banks.
WH Smiths took an LDI route, selling its equity and bond holdings and investing the £870m proceeds in a portfolio of swaps and equity options under the auspices of State Street Global Advisors and Goldman Sachs. (Few doubt there can be little coincidence that it was a year after the under-funded state of its pension fund scuppered a buy-out by Permira.)
According to Mr Jecks, another attraction of the finance director/investment bank relationship is that corporates have been raising capital in various ways to finance their pensions shortfall, often taking advantages of tax relief on interest. Morgan Stanley aided Sainsbury's in securitising its stores to help plug its pensions shortfall.
There is little doubt corporate treasury departments and financial directors are more than happy to listen to the suggestions from their old friends, but the investment banks are buttering up the actuaries and consultants for business too.
But at around this point the waters get, as Mr Bevan notes, ‘murky’. The official line from investment banks is that they work with an actuary in analysing a fund’s risk, then outline a product solution using the consultant to hold the trustee’s hand.
“Investment bank advisory work is typically not charged on a fee basis, but there is an understanding that there will at the very least be an opportunity to compete for any business arising from the advice” explains Mr Quinn. He points out that winning can mean a basis point on a growing revenue base over 10 or 20 years – big bucks. Also for each exotic deal there also need to be counterparties, the traditional role of the investment bank.
Out of the loop
But there has also been much muttering among actuaries and consultants that they’ve often been kept out of the loop when product offerings are suggested and sometimes, in their view, they have been the wrong products. Mr Bevan recognises that one danger in this development of new and complex strategies is that trustees may not understand exactly what they are getting.
At a recent investment conference, organised by the UK’s National Association of Pension Funds, CarnaudMetalBox Group’s UK pensions manager Philip Read criticised investment banks for using language often incomprehensible to the trustees and contended the pricing was often obscure.
Mr Quinn takes the view that many investment banks are struggling to develop closer relations with the consultants, but that he feels that they’re little threat to fund managers. “Our contention is that their service, if provided directly to the trustees, will typically need to be intermediated - the traditional role of the fund manager. Therefore we view this as a potentially symbiotic relationship,” he adds.
The regulatory fact is that for the investment bank to sell a product to a pension fund requires a fiduciary agent and that still falls to the asset manager. Nevertheless, the growing involvement with the corporate sponsors to sort out their pension problems can produce deals that cut out the asset manager.
This also ignores what could happen elsewhere in Europe. There are regulatory differences and in the Netherlands and Scandinavia large pension funds have in-house experts more ready to do business directly.
According to Christophe Pochart, head of solutions for financial institutions at Société Générale, “We should be complementary to asset managers – investment banks can’t do what asset managers do on a daily basis.” Indeed, the main difference between the asset management house and the investment bank remains the asset managers’ ability to provide an ongoing service while the banker works in transaction mode.
There is one area where the asset managers cannot compete and that is in assessing risk. “Investment banks have intensive risk management techniques along with the technology back-up and our use is to implement a risk framework with a scheme’s liabilities in the short- or medium-term, rather than re-investing asset classes in response to new risk,” explains Mr Pochart.
He argues that the role the investment banks should be fulfilling is provision of a product that responds flexibly to situations rather than estimating what the future will be.
But precise roles, strategies and products offerings vary from bank to bank. ABN Amro, for example, says it restricts its offerings to existing clients rather than search for
new business.
Meanwhile old businesses such as transition management are finding a home in the pensions and insurance groups, although it varies from institution to institution. While investment banks have long been in the business of transitioning portfolios, they have faced increased competition from custodial banks and in, some cases asset managers. In a world of smaller returns funds have woken up to value leakage should transitioning not be done properly.
Abbey faced criticism from Goldman Sachs in awarding its transition management contract to State Street Global Advisors, questioning its capability, terms and prices. Essentially the investment banks argue they have more playing power to successfully transition assets, while the asset managers claim a wider number of contacts. The two also differ in accountability, transparency and reporting times and it falls to the trustee to decide from draft papers on best practice.
It is also worth noting that the investment banks are taking other things from these changes. As alternative assets become more and more a part of pension investment and asset managers continue in fiduciary role, they need the technology to price and value
these instruments. That technology is increasingly coming out of the sell-side in the investment bank.
