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Return of the Pension Fund Fudge?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
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?
»
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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.
Everybody (look at any P&L or Balance sheet or Bonus Statement) loved to Mark-to-Market on the way up - why does it then become unfair to do it on the way down? To make an economic science out of it is nuts - the most fun you can have is to read almost anything any economist wrote in 2006 now... Nobody is has the smallest idea of what happens.
Yeah, funny how mark-to-market is "evil" and exacerbated the downturn", which is true to a certain extent, but at the end of the day, HOW ARE YOU GOING TO VALUE ILLIQUID ASSETS???? All these pension accountants will make all sorts of excuses as to why they should SMOOTH everything over five or ten years, but this is just accounting gimmickry. With a stroke of a pen, they value assets UP or DOWN. Total bullshit. The public market guys battling to beat a bond index or stock index know this and they're FUMING watching their private market counterparts at pensions getting away with gaming their benchmarks/ accounting gimmickry. At the end of the day, if you're paying some senior pension fund manager for alpha, make sure it's really ALPHA not LEVERAGED BETA!!!!!!
Leo, question from a pension fund ignoramus (and a Perma Bear) - Does a typical pension fund depend on a certain amount of return on its fixed income ? If thats the case pension funds globally could suffer as governments have rushed to lower their interest rates.
btw.good call on the "equity rush". Got to give it to you. There is nothing stopping this juggernaut.
Low interest rates force pension funds to buy more risk assets like stocks, commodities, hedge funds, real estate, private equity, infrastructure, etc. to increase returns. Problem is that when everyone is flooding these assets with liquidity, returns go down. Private markets in particular are tied to public markets, so if stocks don't keep going up, private equity will not do well. Add to this the structural impediments after the credit crisis which made debt financing a lot harder to obtain and you see why private equity and real estate is stuck in a quagmire. Obviously mark to market will be harsh on these assets on the way down, but if the economy recovers, they'll mark them up. But the economy has to recover and it better be a sustainable recovery.
Pension liabilities and health care are the items that can't be kicked down the road. There are more millionaires in the public sector than in the private sector due to the huge pensions owed them. Every government everywhere will close their eyes to any accounting scam that halts any move to true Mark-to-Market either in pensions or finance.
Also a comment for yesterday - I'm not a gold bug but I've always said that gold is both fractional and fiat UNLESS you have it in your hand. Gold certificates have the same value as any other piece of printed paper.
LEO - push the pension file - keep up the good work.
Populist ICE CREAM....and FUDGE ?
Everybody likes FREE ICE CREAM.....
FREE FUDGE ????
Valuation is a complicated business best not left to accountants or regulators.
That's why valuation professionals started in about 1995 to develop International Valuation Standards, which were first published in 2000 and are approved by every valuation institute of any consequence in the world.
But no one uses them, instead they use various flawed methods of valuation dreamed up by accountants from time to time (and which typically run to less than a page (IVS is 264 pages).
Which is a shame, particularly since IVS explicitly recognizes (a) that the value of something differs depending on the purpose of the valuation (b) sometimes markets are in "disequilibrium" (i.e. they are not "efficient"), in which case the valuer should (1) report that (2) tell his/her client what they estimate the value would be in case the market was not in disequilibrium (3) explain in simple English (or Dutch), why, based on careful consideration and analysis of market derived data.
That by-the-way, is a lot harder to do properly than simply (a) checking what's on the price-tag today, (b) working out the book value, or (c) typing random numbers into a computer and telling yourself that achieved something.
It's harder - not many people know how to do it, it's more expensive, but it's much more likely to get a reliable answer.