From the Flight Deck

I'm a social media innovator and advisor to the financial services industry. I focus on pension plans and how to make them work.

Connect the dots …

From the earliest age we love to connect the dots. On any holiday charter flight, a child with furrowed brow is concentrating hard, drawing lines between numbered dots on a page. Dots that look random and meaningless until the carefully drawn pencil lines finally reveal an etching of the three bears staring in disbelief at Goldilocks asleep in Baby Bear’s bed.

Life is a bunch of dots. It always has been. Some people are better at seeing the picture than others.

A man in ancient Greece lowers himself into a bath of hot water. Dot. The water level rises. Dot. The man knows it always rises by the same amount when he gets in the bath. Dot. It rises by a different amount when his wife, Erika, gets into the same bath. Dot.

"Yo! ‘Rika, maybe there’s a Principle."

A 19 year old geeky kid who’s good at programming creates a simple site so his other sad geeky friends can congregate online to discuss the relative merits of the girls on campus. He launches it from his Harvard University bedroom on February 4, 2004. The site goes wild with activity.

In a couple of hours it overloads the university’s servers. Dot.

He writes some more code so that they can all post cool stuff about themselves and share pictures and “status updates" online. Within a few weeks there’s so much activity it melts the servers of several universities across the US. Dot.

Hey, maybe everyone on the planet - not just sad geeky people - would like this site.

It wasn’t the first time someone had built an online platform for a student community. But it was the first time anyone connected the dots.

Now, those connected dots are worth $100,000,000,000 give or take. It’s not always about creating the dots; usually, it’s about connecting them. Each dot is nothing special on its own. It’s the connecting up that unleashes the power.

Plenty of folk knew about m. They were also familiar with E and c. They were three dots. Only one guy connected them and showed that E=mc2. In other words, matter and energy are really just different manifestations of each other!

In this insanely fast-moving, tectonic plate shifting, technology-driven, austerity-ridden, 2012 world, it is more important than ever to connect the dots.

The thing is, dots just look like dots until someone connects them. Some people are great at connecting dots. Others refuse to see the picture even when someone else connects the dots.

Take Kodak. The iconic brand invented the digital camera. Dot. No messy, hassly, inefficient, expensive film development required with digital photography. Dot.

People can take loads more great pictures than they can with film. Dot.

Phones can double up as cameras. Dot.But Kodak didn’t like that picture (they were all tooled up for a world of glossy film) so they pretended it wasn’t there; as if the dots were just dots. So Sony, Canon, Nikon and Apple connected them instead.

Now Kodak is in Chapter 11 insolvency. Which is what can happen when you don’t connect the dots.

Random Pension Dots

Back in 2003, there were a bunch of random dots:

Regulation and accounting rules suddenly forced companies to treat the highly volatile pension deficit as a real and present debt on the sponsoring company’s balance sheet. Dot.

The major driver of pension deficit volatility was the liability side of the equation, not the assets. Dot.

Only a meaningfully large investment in long-dated government bonds (or, better still, interest rate and inflation swap contracts with similar effect) matched the liabilities. Nothing else. Dot.

Real interest rates began to fall, more or less steadily. Dot.

Pension liabilities are measured using real interest rates. As real interest rates fell, the liabilities rose. Steadily and a lot. Dot.

By 2005 there were a heck of a lot of dots waiting to be connected.

Amazingly, many pension funds and their investment advisors looked at those dots through a Kodak lens. They didn’t like the picture, so they behaved as though it wasn’t there.

When you asked them why they waited to hedge, they typically replied that better times were ahead. This turned out not to be the case.

And all the time, someone else was connecting the same dots and purchasing the very hedges they should have purchased.

What’s done is done. (Or, more accurately, not done).

Now here are some more random dots:

Corporate sponsors are slowly suffocating under the weight of their underfunded, unhedged plans. It is an agonising way to go. Dot.

Corporates cannot take much more of this. The very life blood is being drained from their essential corporate activity - which is already under severe strain due to particularly austere economic conditions created by Greeks, Bankers, Germans, French, the Government, Californian Mortgages, Sir Fred (sic), et al. Dot.

The real yield is now negative and is clearly NOT floored at zero. Dot.

Often, prices rise even when you don’t think they should. Gold, Oil, Gilts, houses in South Kensington. It’s a function of supply and demand. Dot.

The price of gilts and swaps is still rising. Dot.The UK government recently decided (because it can) to print some money (£50bn) and has gate-crashed the gilt-buying party. Dot.

New regulations from the EU are about to force pension plans to manage risk intensively. Some people think it is a good move. Others think it is a dumb move. It doesn’t really matter. It is happening. Dot.

There are not many remaining investment safe havens but gilts are still considered to be among the safest of safe investments. Foreign investors (Greek, Saudi, Libyan, Egyptian, Chinese, Russian, Italian, Spanish, Irish, Portuguese etc) prefer gilts to their own government debt. There is still plenty of demand for UK government debt. Pension funds, the UK government, everyone else are all still buying gilts. Dot.

These austere conditions are not about to go away anytime soon. Profligate ouzonic countries are not about to start behaving like efficient Teutonic citizens. Besides, it is almost certainly, tragically, too late. The ship has hit the rocks and is capsizing. It may take a bit longer, but soon it will be on its side, sliding off the edge of the Euro reef. Dot.

Technological innovation is altering the corporate landscape more quickly than at any point in history, including the Industrial Revolution. Corporations cannot predict who will shortly put them out of business by connecting dots. In 2012, it must be terrifying to be CEO of Iconic Brand PLC. Dot.

Lone individuals with A Great Idea can now severely disrupt the establishment. And to do so costs, er, nothing. Dot.

Those are the dots.

Now here’s an emerging picture. A truly perfect lightening storm is arriving for the pensions industry and the clouds are dark and heavy.

If you run a pension plan (or a corporate sponsor of a pension plan), there is no choice but to implement an effective risk management strategy. Every day you delay, the risks increase exponentially.

The next couple of years will herald the rating downgrades (and, in some cases, the insolvency) of iconic brand corporations that failed to connect the dots.

Either they will be technologically obsoletized (new word) or the cost of their pension deficit bill will take them under. Or both.

For some, there is still time to address the situation; but not much.

Those are the dots.

That is the picture.

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Cry! It’s a Kodak Moment.

In October 2003, a leading finance magazine published an upbeat interview with the pensions manager of Kodaks £800 million UK pension scheme, in which he disclosed details of the plan’s new and daring asset strategy. The scheme, he explained, had invested 35% of its assets across 40 hedge funds with just 2% remaining in equities.

It was a new and different approach, with the ambitious aim of out-performing run-of-the-mill, bog standard, equities
by around 2%. In fact, the whole portfolio had been carefully set up to be diversified and intelligent, seeking additional asset returns.

Light at the start of the tunnel

In the beginning, it was a picture of success: Kodak produced a positive return of 12.1% making it the best UK scheme within the WM2000. Last year it produced a top-decile performance by restricting its losses to -3% against a peer group average of -14% said the article.

In 2004, the UK pension scheme
s property portfolio also duly appreciated in value.

Back then, it is fair to say, it was all looking good.

So much so, that the parent
s 2003 annual report (p31) proudly proclaimed:

The Company does not expect to have significant funding requirements in relation to its defined benefit pension plans in 2004.

That was then…

Today, however, as the embattled US Kodak parent finds itself in the dark room of Chapter 11 insolvency, its badly under-funded UK pension scheme is learning a bitterly painful lesson.

For whilst Kodak’s US high command insists that it is
business as usual in Europe, the glaring harsh reality is that it is highly uncertain, to say the least, whether the UK pension plan will find the £440 million deficit it requires in order to make all the payments due to its present and future pensioners over the remaining life of the scheme. Kodak UK is unlikely to have sufficiently deep pockets.

How did it all go so wrong?

It is not that Kodak failed in 2003 to consider the potential problem of rapidly rising pension liabilities. At the time, the pension scheme manager said:

We are not convinced that future equity returns would generate enough alpha to cover liabilities. Instead, we have taken a diversified approach.

The pension scheme’s management team was plainly fully aware of the risk of unfunded liabilities and believed it had come up with a game plan.

Nor was the new investment strategy impetuous and unconsidered. As the article pointed out:
[The pension scheme manager] has evolved his strategy over time.

And this was no renegade embarking on an unsupervised frolic of his own:
[He] has involved his trustees at every stage.

No. The tragedy for Kodak is
not that the trustees and pension plan managers et al failed to think about the problem. It was, quite simply, that they failed to implement the correct solution.

By way of evidence, and in contrast, just eight weeks later, in early December 2003, a similar sized UK pension plan, Friends Provident Pension Scheme,
did successfully implement a hedge and, in so doing, protected the FP Scheme from its principal predator: the Collapsing Real Yield (CRY!).

The CRY!

The CRY! is a savage beast of terrifying ferocity. It has ripped (and is currently ripping) the beating hearts out of defined benefit pension plans around the globe, pushed pensioners by their hundreds of thousands closer to the cliff-edge of old age penury, and stolen the golden years from an entire cohort of the vulnerable elderly.

The CRY! is ruthless. It propels pension liabilities skywards without a second thought. It drives the
present value of pension plan obligations up into the stratosphere, miles beyond the reach of almost any asset performance. It draws no distinction between private sector and public sector workers.

Between the years of 2003 and 2012 (present day) the CRY! has eviscerated pension plans, brutally exposing those who clung doggedly to the belief that the CRY! was a chimera, a bubble, a mirage, and therefore failed to fight fire with fire. The CRY! is now exacting a terrible price.

Kodak, tragically, fell into that category. It is a reasonable assumption that in 2003 their pension scheme
supremos in Hemel Hempstead (UK) and Rochester (US), considered the risk of the CRY! but, along with many other pension plans, it seems they did not implemented the anti-CRY! solution.

Put simply, in 2003 Kodak faced
three risks:

Risk One The risk of the Collapsing Real Yield! That is, the risk of sharply falling long term interest rates, coupled with simultaneous rising inflation. This toxic combination would cause Kodaks pension liabilities to rise uncontrollably; if the CRY! came to pass, the pension plan would be in serious trouble.

Risk Two The risk of their newly diversified “growth” assets failing to perform the heroic growth targets demanded of them. This would result insufficient assets to match the CRY!-ravaged liabilities.

Risk Three The risk of Kodak (UK) pension schemes sponsoring corporate far away in Rochester, NY, becoming insolvent and leaving the UK pension plan with no external means of support. If, in the nightmare scenario, Risks One, Two and Three all materialised, the pension plan would be cast headlong into the UKs Pension Protection Fund along with an unquantifiable number of other failed pension plans.

Given those risks, it would have been prudent to comprehensively hedge the scheme. But from the size of the deficit today, the signs are that they did not. My hunch is that in the final analysis, Kodak just did not believe that the Collapsing Real Yield would materialise.

Further, they could not conceive that their carefully-crafted diversified alpha-seeking asset strategy would be insufficient to meet the onslaught of the CRY!.

Nor did they anticipate the US mother ship becoming insolvent mid-way through its agreed pension contribution schedule.

Certainly, they never dreamed for a second that ALL three events would occur. But they have.

It is a perfect storm.

Disastrously for Kodak, Risks One and Two have been materialising ever since that interview back in 2003. The Kodak UK pension plans liabilities are now a stunning £1.6 billion whilst the assets are, apparently, a mere £1.2 billion. The CRY! helped to wipe out £440m(!) of assets.

Risk Three
materialised last Thursday.

Game Over.

Ironically, in the 2003 interview, the pension scheme manager made the point that he hadtaken care to consult his sponsor’s corporate treasury department. ‘Which Is only right. After all, the support of the sponsor is the biggest asset we have.’”


So what are the key lessons from all this?

Here are three:

Lesson One: The Sponsoring Corporate can become insolvent. This can occur despite oft- repeated assurances to the contrary from the sponsoring corporate. Super-advanced technology is obsoletizing (new word) established iconic platforms and processes. Kodak somehow missed the digital camera revolution (despite having invented the digital camera)and got blown away by more nimble competitors. Theyre not the first and they wont be the last.

Lesson Two: Attempting To predict the markets and betting the farm that killer risks (such as the CRY!) won’t materialise, is a costly error. If your assumptions, predictions, prognostications and assorted gambles turn out to be wrong, there will be irreversible problems for the pension plan. Instead, you should implement a risk management strategy. There is no alternative.

Lesson Three: It is mystifying why, although Parliamentary and Congressional Hearings are routinely held to consider the sudden collapse of other financial organisations, pension plans that fail are assumed to be victims of a series of unfortunate events.

Why is no-one ever held accountable when a pension plan ends up with materially fewer assets than liabilities and a bust sponsor? Who was asleep at the wheel? What was the advisors’ advice? Where was the Kodak global pensions risk management strategy? Why did the Corporate not take action earlier? What did it choose to spend its cash on instead? Why did the pension scheme’s trustees not bang harder on the CEOs door whilst there was still money in the pot? What was the Pensions Regulator doing?


Answers are important. Otherwise - watch this space - there will be multiple digital copies of this Kodak Moment as the same sequence of events plays out for pension plans and their sponsoring corporates across multiple industries in multiple lands.

Burgeoning Pension Liabilities? Welcome aboard the Costa Concordia.

The rock was not marked on my nautical chart. It indicated that there was deep water below. There should not have been such a rock.

Capt. Francesco Schettino, La Costa Concordia 14 Jan 2012

You are a trustee of a pension plan. It is your responsibility to ensure that the benefits of all the plan’s members are delivered in full and on time.

Or, to think of it another way, you are a senior crew member of a gigantic ocean-going cruise liner. There are thousands of passengers on board - it is more of a floating city than a ship.

Fathers, mothers, sons and daughters, grandparents, are all taking the trip of a lifetime; all trusting that you know where you are taking the ship. They assume that you have a detailed map of the currents and waters in which the vast vessel is sailing.

Of course, they understand the ship may encounter unexpected incidents and eventualities during the voyage - violent storms and suchlike - but this is an ultra-modern ship (it cost 400 million Euros to build). Besides, this is 2012 and the age of super-smart technology. It is the era of Apple and the Higgs Boson. It goes without saying, you and your fellow crew members have access to the most sophisticated charts, maps, radar and sonar technology.

Naturally, the passengers assume, the crew has a gameplan for every conceivable nautical scenario.

So, as they settle down to the divine creamy lobster bisque alongside their fellow diners in one of the stunning dining rooms on board your ship, not a single person contemplates the possibility that maybe, just maybe, the crew has no idea of the ship’s true position.

Or, worse, that the crew does not know that it does not know its location. That this vast vessel laden with several thousand souls may be on the brink of epic maritime disaster. The very notion is absurd.

(Everyone on board has seen Titanic, but that happened a hundred years ago for goodness’ sake and we’ve learnt all the lessons.)

Thus, if, over dinner, anyone was to suggest in conversation between genteel sips of Barolo Granbussia Riserva 1999 that the immense vessel you command might in fact be way off course and headed for lethal rocks in shallow water, that the entire 114,500 tonne ship will shortly capsize in darkness and chaos, that the captain and crew (despite mingling freely with the passengers and exuding a cool, confident, air of professional calm) have no viable gameplan in the event of such a catastrophe, why then, I suppose their fellow passengers would tell them to relax, calm down dear and just enjoy the cruise.

But that is exactly the analogous position of many pension plans today:

1. The long real yield (used to discount pensions) is undeniably negative, forcing the razor-sharp and jagged pension liabilities ever upwards, far closer to the ship’s hull than most captains and crew ever anticipated or planned for.

2. Over the last decade, equities (that staple diet of most defined benefit pension plans) have not delivered those much-vaunted deep sailing waters, and the assets of many pension plans are consequently now a lot shallower than conventional maps predicted they would be at this point on the trip.

3. As the European economy crashes onto its own private Mediterranean rocky reef, the corporate sponsors of many pension plans (or in the case of public sector pensions, the government) are facing challenging financial problems. So whence those promised lifeboats of additional corporate funding for pension deficits?

Not enough of them. Not seaworthy. On the wrong side of the ship. Upside down in the water. Already full. Not fit for purpose. Etc.

Few would argue with the assertion that the pension industry’s oceanic landscape is now dangerously uncharted and unfamiliar.

None of this was supposed to happen. But then, the Costa Concordia wasn’t supposed to sink.

Maybe the pension plan’s captain is at his post on the bridge; perhaps he’s in the bar mingling with the rich and pretty guests; or maybe he is in one of the sweltering galleys below deck, checking on the homemade pasta.


Your mission is simple. Excuse yourself from dinner, make your way to the deck and look over the ship’s rail.

The rocks are so close you’ll be able to see them.  There may still be time to yell down to the captain.

Kauto Star Performance

Every now and then, exceptional form and talent come to the fore and combine unarguably, imperiously, to blow away the competition.

That’s what happened on Boxing Day last year when racehorse Kauto Star won the King George VI steeplechase at Kempton Park for an unprecedented fifth time.

The racing world united in praise for a horse which has been described in the following terms:

ultra consistent, incredibly tough and extremely versatile; he possesses a devastating turn of foot, a unique talent among staying chasers.”

Here’s what we’re talking about in Kauto Star:

He’s the only horse to have won the King George FIVE times.

In his first six years in Britain he competed in 18 Grade 1 races over distances from 2 miles to 3 1/4 miles. He completed 15, winning all but one. His sole 2nd place came in the 2008 Gold Cup to his stable mate, Denman.

His official rating of 193 (given after his 4th King George win) was the highest ever awarded to a Steeplechaser.

Finishing 3rd in the 2011 Gold Cup, Kauto maintained his record of never finishing outside the top three places in any of his 27 completed races in his 7 seasons in Britain.

He’s the only horse to have ever regained the Cheltenham Gold Cup.

He’s the only horse to have ever won two separate Grade 1 (or Group 1) races more than four times (Betfair Chase 4 times and King George 5 times). He also won both races under three different Prime Ministers.

He has won more prize money than any other National Hunt horse in the history of the sport.

He is the only horse to win Grade 1 races in 7 consecutive seasons.

He is the only horse to have won 16 Grade 1 races in total.

Along with Denman he has competed at the Cheltenham festival 6 times in a row.

Thus, Kauto Star is now firmly ensconced in the pantheon of race-horse legends alongside those all-time greats, Arkle and Desert Orchid.

But it would be a school-boy’s error to speak of Kauto Star without also recognising that he is part of an extraordinary double act.

Ruby Walsh is the jockey who brings Kauto Star’s potential to brightly burnished fulfilment. Walsh is one of the world’s great jockeys and has ridden more than 1,400 winners in a glittering career.

At the 2009 Cheltenham Festival Walsh rode a record-breaking seven winners over the four days. On the second day of the 2010 festival he rode Sanctuaire to victory in the Fred Winter Juvenile Novices Handicap Hurdle and therefore became the jockey with the most wins in the history of the Cheltenham festival.

Ruby Walsh understands and rides this phenomenal horse better than anyone, and this incredible once-in-a-generation partnership of horse and rider is the key to the mind-blowing statistics. Indeed, Walsh has ridden Kauto Star on 17 out of his 23 wins.

Kauto Star Pensions
And so to the topic of pensions and the successful management of the valuable, yet scarce, assets required to provide adequately for pension plan members in retirement.

The tectonic plates are shifting fast in this besieged industry.

As it rapidly becomes all but impossible for a lay board of pension plan trustees to navigate the treacherous and volatile markets in which we find ourselves, there is growing demand for a more holistic framework that provides world class strategic advice whilst also managing the assets against the liabilities.

Traditionally, those two functions (advice and asset management) have resided in very different places. Strategic investment advice comes from the stable of the investment consultant whilst asset management comes from the money managing fraternity.

That functional distinction is, perhaps, no longer fit for purpose. These days, pension plans are asking for something different and better.

They want Kauto Star, field beating, world class, asset management AND strategic advice in seamless combination. In other words, they want team work and joint responsibility.

How do you get Kauto Star performance? Not without Ruby Walsh. How does Ruby Walsh lift the King George five times? Not without Kauto Star.

Perhaps the answer to our clients’ request, is to pull off the previously unthinkable: an unbeatable alliance of the world’s best and most versatile asset management with the finest investment consulting services.

The asset manager is Kauto Star. The investment consultancy is Ruby Walsh. The pension plan is the owner.

Audacious yet obvious.

At stake is the greatest prize of all: the on-time delivery of EVERY promised pension payment to the owner’s members.

Just think.

Running a Pension Plan in 2012? You need a 20 Mile March.

In Jim Collins’ latest book (Great by Choice) he offers a compelling illustration. Imagine two people in San Diego, California, who both plan to walk to the tip of Maine on the other side of the USA. It’s a journey of 3,306 miles and they both set off one sunny Saturday.

Guy One walks 40 miles on the first day (the weather is a nice 20 degrees C); he walks 27 miles on the second (equally nice) day. By Day 3 he is on the edge of the desert and the temperature soars. That day he manages only 8 miles - it’s scorching hot and he’s exhausted from walking 67 miles over the previous two days.

In contrast, Guy Two does only 20 miles on the first day. He could easily have done another ten, but he has a clear goal of 20 miles every day. He walks 20 miles on the second day. On Day 3 he is fully rested and manages a decent 20 miles even though it is baking hot.

Guy One cracks on whenever the weather allows but rests up when it’s against him. When he hits the snowy, windy, high mountains of Colorado he covers barely any ground at all. In fact he is so exhausted he catches a heavy cold and has to stop for a week.

Guy Two just does his 20 miles every day. It’s a 20 Mile March whatever the weather. No exceptions. It means he arrives in Maine several weeks before Guy One. In fact, Guy One is lucky to make it at all, such is his inconsistency and hopeless reliance on the weather.

Collins is neatly illustrating the benefits of solid consistency over fair weather sporadicity. The former always wins out in the long term.

Tip One. Adopt a 20 Mile March approach to managing the risks in the pension scheme. You have no way of forecasting when it will be a 20 degrees (C), perfect, sunny day for hedging the real yield.

The best economists, asset managers and investment consultants have tried and spectacularly failed to predict “the right time” to hedge against this most pernicious and insidious of risks.

That’s why every newspaper is headlining “Pensions Massively Underfunded as Liabilities Soar.” What they should be screaming is: “Pensions Massively Underfunded as Unhedged Liabilities Soar Due to Systemic Failure to Implement a 20 Mile March Strategy.”

There is only one effective approach: The 20 Mile March. Hedge a bit of your risk every month until it is all hedged. No pension scheme that has taken this approach at any point in the last 10 years now regrets it. Not one.

Since Dec 2, 2003, when Friends Provident Pension Scheme hedged its risk, many others have embarked on their own 20 Mile March (vis-à-vis hedging risk, diversifying assets, achieving target funding levels) and are now sipping a dry Martini on the verandah of the highly rated Bayview Hotel, Bar Harbor, Maine.

If you are still huddled in a snowbound cave somewhere in the Colorado mountains waiting for sunny blue skies, chances are you didn’t have a 20 Mile March Game Plan.

It’s (probably) not too late.

Tomorrow, whatever the weather, do 20 Miles.

Waleed and the Accounting Standards Board

Here’s a blog I wrote on 17 October 2005. Even then, the writing was on the wall:

Last Friday, I had occasion to spend an afternoon in Frankfurt and after my meeting I hailed a passing cab. “I need to get to the airport sharpish, bitte,” I said to the driver. “Kein Problem!”, he replied, “Mein Name ist Waleed und ich komme aus Afghanistan” before achieving the doubly impressive feat of driving at 200kph whilst simultaneously chatting to his father on his mobile phone.

In fact, it took less time for Waleed to drive from the centre of the city to the airport than it did for me to get through customs and security. These days, Frankfurt Main’s security is seriously tight - you walk through a metal detector, your belt and shoes get X-rayed, then they scan you with a handheld device and finally they pat you down in a decidedly Teutonic, no-nonsense, kind of way.

A hundred yards further on and they do the whole thing again. Some might say this level of scrutiny is a serious inconvenience. And at one level they’d be right. By the time you’ve jumped through all the hoops, you stand every chance of missing your flight. But on balance, most people would rather jump hoops than have the wrong guys slip on board the flight with them.

And so to the Accounting Standards Board’s announcement last week that it is carefully considering whether FRS 17 needs to be adjusted in any way. The reason seems to be that the ASB realises how incredibly important FRS 17 has become and wants to be sure this exacting accounting standard is neither too stringent nor too lax.

But the ASB is giving little away and the industry is desperate to know which way it’s going to lean. No doubt some are hoping FRS 17 will be consigned to the dustbin - it’s the CFO’s equivalent of Frankfurt security and very inconvenient; first you get X-rayed as you discount your pension liabilities using a bond yield and apply a true market level for long term inflation.

Then, as if that’s not enough, the Pensions Regulator pats you down and if he finds any spare cash, firmly suggests you put it into the pension scheme.

Several companies are finding that the unrelenting scrutiny is delaying their strategic plans. If your scheme has got a big deficit, then before you IPO, buy back shares or sell off assets, you need to think about the pensions regulator, because he’s watching.

With some companies missing their flights, they’re fervently praying the ASB will scrap the 17th financial reporting standard. Don’t bet on it. Mark to market is now the global norm and besides, for trustees, FRS17 and the the pensions regulator are the two best things that have happened - because they have encouraged corporate sponsors to hedge risk and start making material additional contributions to the scheme.

You see, despite FTSE’s storming rise in the last couple of years (faster than Waleed on his way to the airport), the deficit has still got bigger.

And it’s only at the FRS 17 X-ray machine that it shows up.

Four Attributes of Pension Trustees Who Take Decisive Action

At 11:00 on a freezing morning - 2 December 2003 - Friends Provident Pension Scheme took decisive action.

The scheme implemented a landmark hedging transaction fully protecting itself against falling interest rates and rising inflation.

They were the first pension scheme to do so, and they set in train the multi-billion hedging transactions that have since become commonplace and are known generically as Liability Driven Investing or LDI.

It was the culmination of months of discussion and planning. Even so, the fledgling inflation swaps market was extremely thin coming up to Christmas and this was a very long dated and large derivatives transaction. In fact, back then, it was the largest of its type to date.

I was working alongside my favourite trader, Jon Mitchell (Merrill Lynch’s Head of Inflation), Rob Gardner (now Co-CEO at Redington) and legendary ALM guru, Philip Rose. For us, it was like landing a 747 on the Hudson.

For Friends Provident Pension Scheme, there was no precedent for a pensions-hedging transaction of this size or type and, at the time, it flew directly in the face of conventional wisdom.

Nonetheless, exactly eight years later to the day, the transaction has proved far more effective than any of us involved with it would have believed possible. The 30 year real yield on 2 December 2003 was 2.13%; these days it is below 0%.

That utter collapse of the real yield (i.e. a sharp fall in interest rates AND an equally sharp rise in inflation expectations) should have cost the pension scheme around £213 million in increased liabilities; but it hasn’t. Why not? Because against all the odds, it hedged that very risk.

Many much larger pension schemes still haven’t hedged. In some cases that failure to take decisive action over the last eight years has added billions to the liabilities.

Why is it that some pension schemes consistently take effective, decisive action, whilst others do not?

Here are FOUR key characteristics of pension scheme trustees who DO consistently take effective, decisive action:

1. They examine the Hard Evidence and act on it - regardless of Conventional Wisdom.
The first time I presented to Paul Cooper (Friends Provident’s in-house actuary) the proposal to de-risk the entire £600 million pension scheme, there were two simple numbers we discussed for over an hour. Just two numbers.

The first was the amount by which Friends Provident Pension Scheme’s liabilities would increase given a micro (0.01%) fall in interest rates. That number was just over £1 million. Imagine that for a second. Interest rates move around in the traded capital markets all the time; and the tiniest of tiny moves jacked up the liabilities by a million quid!

What’s more, this implied that a one percent fall in interest rates would ratchet up the pensions bill by more than £100 million. No-one was predicting a one percent decline in long term interest rates, but that wasn’t the point. If it happened, the pension liabilities would rise by an insanely large amount.

The second number we discussed in meticulous detail was the amount by which the pension liabilities would increase for every micro (0.01%) rise in inflation expectations. This number was also circa £1 million. Which meant that a one percent rise in inflation expectations would drive up the pensions bill by just under £100 million.

The nightmare scenario in my presentation was a world in which interest rates FELL by 1% AND inflation ROSE by 1%. The pension plan would take a combined hit of £200m!

But the chance of interest rates declining with inflation simultaneously rising was non-existent. Colonel Gaddafi had more chance of becoming the Pope. At least, that’s what Conventional Wisdom said. Conventional Wisdom back in the day reasoned that if inflation rose, the Bank of England would inevitably raise interest rates to bring it back down. It would be automatic, a sure thing. Guaranteed. Newtonian physics.

A world in which interest rates could fall by 1% and inflation could simultaneously rise by 1% was the stuff of pure fantasy. This was one of the first things one learned at the LSE. To suggest otherwise, just showed you knew very little about Economics.

An hour into our discussion, Paul and I both agreed that if interest rates fell and inflation rose it would be an unmitigated disaster for the pension scheme. There were simply no equity-like assets that could offset that kind of damage. What we just could not agree on was how likely that scenario was to materialise.

So we went back to the evidence.

We were on the sixth floor of the Merrill Lynch offices in King Edward Street overlooking Paternoster Square. The table was strewn with empty coffee cups. All the water bottles were empty; fizzy and still.

Persuade me”, Paul said. “You have my undivided attention.” (I had written an article for Finance Magazine saying that unhedged liabilities were the elephant in the room but, in order to be convinced, Paul demanded more evidence than I had yet presented).

I made three arguments:

Argument One: Over the previous 100 years, the real yield had been down to zero on several occasions. Indeed, the “normal” levels of 3 or 4% (and the floor of 2%) so readily quoted by Conventional Wisdom were the outliers, the exception, NOT the norm. We had experienced zero percent real yields in the past and we would likely see them again. I had 100 years of data and the 100 year graph.

Argument Two: The risk of materially lower real yields was a risk the pension scheme JUST COULD NOT AFFORD TO TAKE! If Conventional Wisdom was wrong, the entire pension scheme would be in jeopardy. And, crucially, in 2003, a hedge was relatively affordable. Why wouldn’t you??

Argument Three: A new era of transparency (post Enron / Tyco / Worldcom) had ushered in sweeping changes to global regulation and accounting rules. Pension schemes were suddenly forced to mark their liabilities to market and report them as a debt, squatting like a giant toad on the sponsoring corporate’s balance sheet. No exceptions.

It seemed reasonable to infer that this development would inevitably spur ALL companies to compel, at all costs, their defined benefit pension schemes to manage the volatility of the pension deficit. Which, in turn, would mean that demand for gilts and swaps (as hedging instruments) would soar. In the absence of massive increased gilt supply, the price of gilts would rise in the coming years, and would keep rising.

And if (as seemed plausible, even probable) the government decided to take the same uncompromising “mark to market" approach to its vast unfunded public sector pension liabilities, that would have an incredible impact on the price of gilts (upwards) and their yield (downwards).

That, in turn, would cause all defined benefit pension liabilities to sky rocket to infinity and beyond, since pension liabilities increase at warp speed as yields fall.

If the Land of Mordor (aka Negative Real Yields) did materialise, then failure to hedge, I argued, would prove catastrophic. Maybe not for several years, but eventually it would prove fatal.

We went over it and over it. Again and again. Paul was wrestling with the fact that no-one else shared this view, no other pension scheme had done such a transaction and last, but not least, he would need to persuade an entire board of trustees (and the Board of the corporate) of some seriously unconventional wisdom. It was a huge ask.

We had been talking for the entire afternoon. Finally, he leant back in his chair. “OK. I get it, I buy it, I’m going to make it happen.”

And he did.

Paul Cooper is an intriguing guy. He’s softly spoken, completely bald, highly intelligent, he has an acute, dry sense of humour and a gift for getting to the point.

He doesn’t tire of interrogating the evidence and calmly persisting until, Columbo-like, he gets a satisfactory answer. He is also an actuary with years of experience dealing with banks, asset managers, advisers and trustees. Back in 2003, he was almost uniquely qualified to guide the pension scheme through the labrynth of capital markets, derivatives and pension maths necessary to “make it happen”.

2. They have advisers who think Outside the Box and understand the Big Picture
In 2003, I was an investment banker, not an adviser. This was a problem. As I pitched my apocalyptic world view of negative real yields and soaring liabilities I (mostly) met staunch resistance. Adviser after adviser argued that hedging against a falling real yield was a complete waste of time and, more importantly, money. If any hedges were to be implemented, it was to protect against falling equities, not the real yield.

But it turned out that Friends Provident were advised by Towers Perrin, a firm who were willing to be persuaded of the benefits of hedging against a falling real yield.

Mark Duke and Steve Bonner, two of Towers Perrin’s leading consultants, picked up the ball and ran with it. Without them, it would never have happened. I could cite 50 pension schemes who considered hedging in that year, but simply could not get their investment consultant to sign off on the strategy. Too expensive. Misconceived. Irrelevant. Too complicated. Wrong level. And so on. In that year, I heard them all.

3. They have an effective governance structure that allows the trustee board to make key decisions and implement them rapidly
One of the fundamental flaws inherent in the board structure of the traditional pension scheme is that decisions are typically made by committee; much like a jury. This can easily lead to stalemate and paralysis.

Another, is that it meets too infrequently to allow sufficient time for proper discussion. A typical board meeting may have up to ten items on the agenda, six of which are major topics each worthy of a day’s debate.

Yet another, is that The Decision often requires a level of expertise that many trustee boards do not possess. In my experience, if you don’t have a couple of investment committee members who really know their capital markets kung fu, you’re much less likely to be able to respond to the swirling fog and changing landscape. You might get lucky and make the right call, but that’s hardly the same thing.

Going into 2012, with the level of uncertainty and market volatility we are facing, every pension plan should be ramping up the level of in-house expertise. Every trustee should be devouring daily, real-time market intel and quizzing market experts. Just as the flight crew pores over data before and during the voyage. They don’t wait until they’re in the ice storm 30,000 feet over the Atlantic before they come up with a game plan.

One long-serving pension trustee whom I know well, recently resigned from the board because, in his words, “I’m not the right person for this job. I don’t have the skill set.” That was an incredibly courageous step to take, and it was the right one.

He has now been replaced by someone with 20 years of battle hardened experience in the capital markets. Someone who has spent the last 20 years assimilating complex data and making fast decisions in fast markets. That pension scheme’s governance level just rose sharply and the switch will undoubtedly save them a lot of time and money in the years to come.

4. They are never lulled into a false sense of security
Just because there are monthly board meetings doesn’t mean “it’s all in hand”. It just means there are monthly board meetings. Unless EVERY board meeting is spent looking at current market data, analysing current pension plan data, weighing current expert opinion and taking specific pre-planned actions as a consequence, those board meetings are not much more than an alternative way to spend a Thursday in nice company.

Pension schemes that today find themselves fully hedged, owning lots of valuable gilts and well diversified growth assets aren’t in that position due to blind chance. They didn’t just get lucky. They did the difficult maths, counted the number of days left before the scheme starts to eat itself, fired some managers, hired others, scenario-stressed their assets and liabilities, looked at the PV01 mismatch between their assets and liabilities, calculated their negative convexity and risk, asked their consultant hard questions, assumed there would be an ice-storm and then took decisive, rapid action.

The Take Away
Pension plans that have not hedged are now in a very difficult place. In these market conditions, there are very few choices and no luxuries. But for some, it’s not too late. There are hard decisions to be made in the short time remaining.

For example, there is a valuable illiquidity premium to be achieved from certain asset classes and there is still a disciplined hedging program to be implemented (YES!) even at these levels. The iceberg looms large against the night sky, but implementing the principles above may help avoid a full-on collision.

Maybe. I read in Financial News that several hedge funds are starting to short those companies whose pension plans have not hedged. The killer predators have done the maths (it’s not hard) and worked out that, for some, it is already too late. The deficit contributions bill that will be presented to the corporate sponsor some time in the next 12 to 24 months is likely to be so large, it will ultimately wipe out the entire corporate group…

If You can see the dreams of Men and Women

Click on this blog I wrote six years ago.

Funny old world.