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Type Working Paper
Scope Discipline-based scholarship
Title Safeguarding Pensions
Organization Unit
Authors
  • Jürg Syz
  • Bernard Dumas
Language
  • English
Series Name Worldwide Mastering Series, Financial Times
Number 6
Date 2006
Zusammenfassung High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. See our Ts&Cs and Copyright Policy for more detail. Email ftsales.support@ft.com to buy additional rights. http://www.ft.com/cms/s/2/e0214e30-ebf8-11da-b3e2-0000779e2340.html#ixzz1fwA6csb2 Pensions are among the biggest financial assets that most people will ever own. So why is it so difficult to insure them? To understand how urgently a solution to this problem is required, one need only consider the factors behind the collapse of so many pension schemes around the world in recent years. Historically, most pensions were “defined benefits” (DB) plans, under which specific levels of benefits were guaranteed to pensioners and investment risks were borne by the sponsors. Since the promised benefits of a DB plan resembled bonds more than equities, the convention of matching assets to liabilities obliged pension funds to hold a large proportion of bonds. However, this often produced disappointing returns. A report by Watson Wyatt, a UK pensions consultancy, in December 2003 estimated that “contributions of 10 per cent of salary produce benefits expected to be about 25 per cent of average revalued pay after a 30 year career, if invested in inflation-linked government bonds. If invested in equities, the equivalent benefit is expected to be about 48 per cent, although the actual level would be subject to much greater variation and uncertainty.” Confronted with this choice, the trustees of many pension funds sought to benefit from the high stock market returns of the 1990s by allocating a large share of the pension assets to equities. They were encouraged to do so by their sponsors, who obviously wished to reduce costs. As a result of this shift, and the subsequent bear market, pensions in many countries are now seriously under-funded (see graph). Instructed by this dire experience, many companies have switched to so-called “defined contribution” (DC) plans, under which employees can diversify and calibrate their risks. But most employees are not savvy investors. Intermediate solutions have been considered, such as cash-balance accounts, which provide employees with some guarantee of minimum returns. However, like DB plans, these have one major drawback: they are risk-sharing arrangements between one group of beneficiaries and a single company, which might fail. In other words, the beneficiaries bear a concentrated risk; they are, in effect, unsecured lenders to the sponsoring companies. Alternative layers of protection The solution we propose is a financial construct or institution called a “collateralised pension claim obligation” (CPCO). Its structure is based on mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs), which are now common in the credit risk market. Pension beneficiaries, who currently hold a claim on the company for which they work, would trade in their claims to the CPCO. This way, the CPCO would accumulate claims on many companies and would be naturally diversified. In exchange, the beneficiary would receive a claim on the CPCO. These claims would be organised in tranches. The senior tranche would be practically riskless as it would be protected by the other tranches. Furthermore, there would be mezzanine tranches of intermediate risk. The equity tranche of the CPCO would be distributed to speculative funds. The tranches would offer different guarantees. The senior tranche would provide a level of retirement income that was unconditionally fixed (in real terms), the same way an annuity currently does. The mezzanine tranche would offer (in exchange for the same original claim) a higher expected level of income but with a lower and weaker guarantee. The higher expected income would come from a bonus that would be paid when and if the value of the CPCO’s assets did better than anticipated. Such a scheme would spread the impact of any individual loss to a large community. It would also give beneficiaries access to a standardised but rich menu of pension guarantees. These advantages could be made available equally well before or after retirement. And the choices to be made by beneficiaries would not require them to be financial wizards. There would also be many indirect advantages. For example, we envisage a situation in which the CPCOs would trade pension claims to optimise diversification and balance their assets according to a number of characteristics such as age, industry and location. Pension claims would be pooled according to these characteristics in the same way that loans are pooled in the mortgage industry. The pools could then be traded between CPCOs and other companies. If the market were active enough, pool prices could be quoted on a daily basis and used to value a company’s pension fund liabilities. Such valuations would be much more useful than those now calculated by actuaries every other year. At present, companies rely on actuarial valuations to determine how much they should contribute to their pension funds, but the efficacy of the discounting methods involved is debatable. And no CFO wants to find their actuaries disagree with their shareholders and analysts over pension liabilities. If pension claims prices were quoted regularly, one could construct market indices. These could then serve as benchmarks to guide and evaluate the investment management conducted on behalf of pension funds. Currently, in many countries, notably the UK, the management of pension fund assets is farmed out to specialised, external managers. These are evaluated on the basis of specialised benchmarks corresponding to their mandates. Thus, if a manager’s mandate is to invest in commodities, they will be evaluated against a commodities benchmark (or an index of their peers). So-called liability-driven investment (LDI) is now in vogue in the investment management industry, but it is only feasible if a reliable benchmark for the liabilities under consideration exists. Clearly, pension liabilities should serve as the benchmark for the overall management of pension assets, since the overarching goal is to be able to guarantee benefits to pensioners. Another problem with DB plans and intermediate systems, in which companies provide some degree of guarantee, is that they are fraught with moral hazards. For example, the companies have an incentive to influence the pension fund trustees or directors to pursue riskier asset allocations than would be warranted if they decided in the best interests of beneficiaries. This is because the higher expected return of riskier securities allows the company to reduce the expected value of its future contributions, while the beneficiaries bear the risk of an underfunded plan if the company goes bankrupt. Such problems are clearly demonstrated by a recent survey of all the UK’s pension funds carried out by Joao Cocco and Paolo Volpin of London Business School. They found that “pension plan trustees who are corporate insiders will invest a larger fraction of the pension plan assets in equities, especially if the sponsoring company is highly leveraged” and, therefore, more likely to go bankrupt. The pension claims pool market: obstacles to implementation Our proposed scheme is not without its difficulties. For it to work, there would have to be a good volume of trading in the pension claim pools, and these would carry a so-called “longevity risk”. That is to say, an individual pension claim would turn out to be more valuable if a person lived longer. Individual longevity risks would average out in a pool, but the aggregate longevity risk would remain. Equally, medical breakthroughs could lengthen the lives of people unexpectedly. So, would financial markets be willing to trade that risk? Encouragingly, three ways of doing so are already in use. First, the annuities offered by life insurers, which make fixed payments that continue until death. Potential beneficiaries seem to underutilise annuities, which may imply that their prices are not appealing or that insurance companies are not keen to take the corresponding risks. Second, the securitisation of life-insurance policies, which has opened a secondary market for longevity risk. Third, the so-called “mortality bonds” launched in recent years. Swiss Re issued its first mortality-linked securities in December 2003, while EIB and BNP Paribas launched a longevity bond in November 2004 to cover aberrant mortalities. Unfortunately, the EIB/BNP bond has been undersubscribed, but this is widely seen as a mere “teething” problem. There should be enough market participants with a rationale to both supply and demand these bonds, especially while pension funds continue to remain vulnerable worldwide.
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