The protection fund is essentially an insurance policy for the worst-case scenario but many are unconvinced that the £400m pledged will be enough to cover shortfalls.
In the Netherlands, the Dutch National Bank is working with the government to create new financial rules for funds, pushing them towards liability-driven and conservative investment policies.
For funds to perform well they would be wise to look at the full product and service range available from consultants and custodians. However, all the options available will not be to everyone’s tastes, and pension funds must be careful not to expose themselves to additional risk – the industry is in a perilous enough position already. But equally, if funds are too cautious, there is a danger they may freeze up and fail to gain advantage in the market when opportunity presents itself.
Change in situation
Regulation has taken its toll on trustees, says Dave Green, head of relationship management, pensions, at HSBC’s Institutional Fund Services Europe. He says many trustees’ responsibilities are well beyond what was expected when they took on the role. Whether looking at changes to international accounting standards or anti-money laundering rules, corporate governance is at the top of the agenda. Add to this the growth in the number of pension beneficiaries as the general population ages and we can see why the term ‘crisis’ is associated with the industry.
Sue Curtis, new business development executive at JPMorgan securities services, says the regulators are not easing the burden: “With the EU pensions directive being embraced in September, there’s talk of ensuring all schemes are fully funded. Clearly that is not very practical in the current environment.”
But, as she points out, the bad turn of events is only a recent occurrence. “A 30-year bull market meant that it was no bad thing for pension funds to have exposure to equities. Companies did have contribution holidays or substantially reduced contributions as a result of equity performance. It was only when the bear market arrived that the pension funds were challenged.”
A rock and a hard place
She believes that the question for funds now is whether they should take a more lateral approach to the asset classes being used – for example, interest rate swaps and inflation-linked swaps. In this area, the custodian must be able to support its customer through independent valuation of these instruments.
Not all funds are in the same position of course – while many are in deficit, there are a few in surplus. There is a clear need for the former to regain ground and the latter to maintain their positions – and, in both cases, trustees are under pressure.
Colin Black, director of insured business at Aegon Asset Management, notes that the experience of the past five years may have led some pension fund trustees to be wary of the advice that consultants have given them previously. “They may feel that they weren’t sufficiently warned – or warned at all – about the levels of risk they were exposed to in terms of the mismatch between the assets and the liability. I suspect that’s made certain trustees sceptical of the investment/actuarial advice that they’ve been getting from the consultants,” he says.
That doesn’t mean that it will be easy for any company to move into this space. Trust law indicates that the determination of whether an action is reasonable is based on whether others would also act in the same way and that means getting an initial client in the field, having no precedent, can be difficult.
Custodian banks shouldn’t suffer too much from this disadvantage, due to their exposure in the market; however, many would be reluctant to replace the role of consultants. Many banks now offer supplementary advice for trustees to give validation to their decisions. Alasdair Reid, head of State Street’s UK Asset Owner Group, is at pains to point out that he wants to add value to a relationship rather than replace value gained elsewhere. “I’m not saying in the slightest that we’re going to try to compete with the consultancy profession,” he says.
He adds that the level of quasi-consultative resources that exist within banks has been recognised, and that it can assist trustees in what is clearly an onerous task.
Given the range of options available to funds and their natural desire to avoid any further risk, a large bank with a ‘big picture’ view of the market has the potential to provide information that can greatly assist in decision making. Other banks are willing to offer both investment consulting and actuarial advice.
At HSBC, there is a broad range of options available to trustees. “A big, global bank can provide a lot of solutions, not just through the custody division but also around these other services where we have a lot of independent functions that are tied together to make an integrated offering through a pensions solutions group,” says Paul Stillabower, head of business development, Europe, at HSBC Securities Services.
Separate disciplines
Fred Green, loans & investments manager at the UK’s Teesside Pension Fund, explains the fund has strong views about distinguishing between service providers. “We believe that the different disciplines should be kept separate. Our actuary is not our investment adviser. Equally, the custodian should stick to matters which are relevant to the custodian. There is a grave danger there of conflict of interest,” he says.
Mr Stillabower notes that there are advantages to the bank’s model. “You have the benefit on the cost side due to powerful pricing through bundling of services.” He acknowledges there is a trade-off between having one large-scale provider compared with multiple providers, but says: “If you’re putting all your eggs in one basket, make sure it is a big basket held by someone you trust.”
HSBC’s Mr Green also stresses that any consulting is performed by a different part of the group to that which provides custodial services, reducing any potential conflict of interest: “They tend to be advising on investment strategy, as opposed to which custodian to choose.”
Other non-traditional options for funds are being sourced. ABN AMRO recently announced the provision of continuous linked settlement (CLS) to Dutch pension fund ABP as a third party, reducing settlement risk for foreign exchange and freeing up its counterparty limits.
FX is not only a vital tool for hedging – for example, ABP strategically hedges all of its US dollar positions to the euro through combinations of spots and forwards – but funds are also trading FX as an asset class in its own right, taking tactical positions in trading currency options. Clearly, being able to exploit broader ranges of assets fully while reducing risk can be a strong play for funds, whether they are maintaining a surplus or trying to reduce a deficit.
Products on offer
Of the products on offer to funds, Ms Curtis says that the more traditional fixed income/equity mix is not achieving the results required. Although Mr Green of Teesside Pension Fund says that it can be difficult to persuade trustees that certain types of assets are worth addressing, some JPMorgan clients are looking more broadly at over-the-counter derivatives use and the bank’s ability to value those instruments independently was critical to the funds’ final decisions. The bank would typically go out to five investment banks and then provide clients with a weighted average price. Although there are concerns about trustees’ comprehension of the products, Ms Curtis notes: “When using instruments for hedging purposes, diversification always has to be a good thing. Concentration is generally not healthy.”
The option of working with hedge funds has also raised concerns but Ms Curtis believes that pension funds could do well through this strategy – as long as they pick the right ones.
Again, that comes down to the advice that the trustees are receiving. Sander de Greef, director and head of the Dutch pension team at ABN AMRO, says that in the Netherlands, more sophisticated clients are investing in hedge funds – although this is not to the same scale as in the US, where larger allocations may be invested. Amounts in Europe are often no more than 2%-3% so the risk of exposure to any ‘bubble’ is far smaller.
Custodian services
Custodian banks themselves can offer a number of services – such as performance measurement, securities lending and asset/liability management – separately to any pure consultancy. The additional revenue streams and governance levels are intended to allow the funds’ investment strategy to match the stakeholder requirements better. Although use of these varies, a number of funds are seeing the benefits, says Mr Green.
“In addition to core custodian services – settlement, collection of dividends, foreign exchange – a number of other local authorities that I am aware of do use securities lending and use it quite successfully. If we were to adopt a securities lending programme, we would almost certainly use our custodian bank to manage that,” he says.
Certain circumstances dictate whether funds are happy to work with a single provider in this area. Where UK local authority pension funds are concerned, there are strict rules involved in tendering for custodian business regularly.
Mr Green explains that this can create difficulties, as the amount of functions involved in the deal increases – at Teesside they must tender for business every three years (or up to four years at their discretion).
“If you do everything through one custodian and you do go out for tender – as we are obliged to – should we change custodian, everything changes. It is a big enough shift changing custodian. If there are many other services involved, I believe it makes the fund vulnerable,” he says.
State Street’s Mr Reid is clear that differences between the funds must be recognised by service providers as solutions need to be customised for the client. “We don’t have a ‘black box’ approach where one size fits all. We have to customise solutions.”
Perhaps unsurprisingly, the custodian is seeing the majority of interest around liability-led investing, risk measurement and compliance monitoring. “These are areas where trustees are spending much more time than they would have in the past,” he says.
Although this burden is intended to safeguard the pension beneficiaries, it is limiting potential for many. As Ms Curtis says: “The challenge will be how do you make an impact on the deficit, and I haven’t seen too much of that yet.”
Ultimately, in the low-return, low-interest rate environment of the foreseeable future, funds will have to be clever in structuring their strategies, and ensure the assets, and the way they are structured, match the pension funds’ liabilities.