There’s no doubting Jeroen’s brilliance – here he goes off on one; two questions – is anyone listening ….and is he bonkers?
Yes, I have resolved the pension crisis. And thank you LinkedIn, for providing me with the soapbox to proclaim my outlandish thinking.
When an ordinary company is in trouble, the logical solution is often a recapitalization: ordinary shares, pref shares, bonds or loans are issued to strengthen the capital position of the balance sheet.
Pension plans, being long term investors, have traditionally been amongst the parties providing capital to such corporations. However these days, pension funds have similar problems, with funding levels being significantly under threat.
So, the question is; Can a pension plan access capital markets in the same way a company can, to recapitalize its balance sheet?
A pension fund is obviously a very different organization to a commercial business. A pension fund pays no tax, makes no profit and can not issue stocks or shares.
The corporate sponsor may of course reduce contributions if things go well, but will be required to make additional payments if things go badly. A shareholder without ‘limited liability’, if you wish.
Some years ago, General Motors took the drastic step to issue huge loans and use the proceeds to fund its pension plans. The car-maker came close to the abyss during the credit crisis, thanks in part to crippling interest payments, but the pensions of workers were rescued.
A pension plan itself can not issue additional shares to improve its capital position, but can they borrow money? Issuing loans achieves nothing: Although you have more capital available to invest, your liabilities go up too.
Years ago some of the banks and insurance companies had similar problems and a solution was found: hybrid financing. Hybrid financing increased the capital without diluting existing shareholders too much nor did it endanger existing creditors claim over existing assets. “Subordinated Debt” was born.
These specialist loans offered investors higher returns at a higher risk, and the hunger for ever increasing returns meant that these loans turned out to be a great success.
Can pension plans issue hybrid loans? The sponsors would be better off as the pension schemes funding gap is reduced. Participants of the pension fund are better off, because the coverage ratios rise and they rank senior over any subordinated debt holder.
Hybrid debt is the same as raising equity, not issuing debt. If invested properly, investment returns should increase as well.
Today, with most sovereign debt instruments trading at significant negative yields the search for return has truly taken off again. However, investors are demanding high standards in transparency and reporting, which is still in its infancy at pension plans. And pension plans have no credit rating. Most rating agencies would not know where to start with the valuation of a pension fund.
A buyer of a hybrid loan issued by a pension plan should therefore have a thorough knowledge of how a pension plan works. Also, this investor should understand local regulations, working conditions, bargaining power of workers and future wage/salary developments.So which buyers have all that knowledge? The sponsor (employer) ofcourse and the local regulator or the government are all intimately familiar with these issues.
When i first suggested issuing subordinated debt to a pension customer in 2006, colleagues said I was mad. In 2010, I wrote an article in a local pension magazine on the subject, and got a few raised eyebrows. But in 2012, AkzoNobel lent its Dutch pension scheme 100mln in the form of a subordinated loan, and raised the funded status of the scheme.
But here is the controversial bit of my proposal: The pension schemes themselves should buy each others subordinated debt, if the corporate sponsor is not willing or able.
Before you all start yelling “Ponzi scheme!“, please continue reading. Because what we have created, is a cross market syndicate of pension plans. All issue subordinated debt, and buy shares in an entity that buys all these bonds.
These shares will register as common stock on the balance sheet, so the assets under management increase. The liabilities side of the balance sheet will now feature accrued benefits, reserves and a subordinated loan, and everybody’s funding level will have increased.
Problem solved? Well, yes and no. Some will argue the change in accounting treatment would be purely cosmetic. However, the structure does now work as a collective insurance trust: If one pension plan defaults on their sub debt, because they need the cash to make pension payments, the syndicate picks up the bill.
It is not a magical solution to underfunding, but a collective insurance scheme, based on pension fund issued hybrid debt, is not completely nuts either. It could improve governance at pension schemes, improve transparency and reporting. It could also create a stronger solidarity amongst pension schemes and a common cause in avoiding failing funds and defaults.
Jeroen – I am sorry to say this really doesn’t solve anything. The funding status does not improve, though beneficiaries would have marginally greater security in the sense that pension claims would be superior to the debt claims. However, issuing such debt would also weaken the position of many pension beneficiaries since there would be coupons that are paid ahead of many later pension payments. Moreover the cost of this debt would be very high indeed – it is subordinated. Unless you have a way that the scheme can borrow this expensive money and reinvest it at higher returns, all that you have done is defer (probably) marginally the date at which the fund fails.