With their bottomless balance sheets and engineering abilities, investment banks have positioned themselves to move into the defined benefit space. But are they welcome and is there room for everyone? Jenny Blinch investigates
As pension funds can attest, the last three years have seen concerted efforts on the part of investment banks to muscle in on the defined benefit (DB) pensions solutions space. Spying a gap in the market apparently left wide open by the rash of accounting and legislative changes seen in the UK, the Netherlands and the US in recent years, most investment banks have moved to set up pension advisory groups with the aim of being the third pillar in an industry traditionally supported by asset managers and consultants.
"Why might banks be doing this in recent times?" asked Kevin Carter, head of JPMorgan's European Pension Advisory Group. "Pension funds are to a greater or otherwise degree legacy for most listed companies, so therefore corporate CEOs are saying, 'Why am I invested in this stuff? Why do I have this? These are past promises.' We believe as a bank these corporate obligations will pass off the corporate balance sheet into the capital markets. It will take several years, it will take several forms - some of which might not have been invented - but the reality is that it's going to happen like a big tidal flow."
Exploiting their financial engineering capabilities and huge balance sheets, investment banks have set out to make pensions risk management their own. Interest rate swaps, inflation swaps and most recently products targeting longevity liabilities have been the offerings most commonly launched at the defined benefit market, along with hedges designed to protect funding ratios and products designed specifically for liability driven investment. The nature of these products means no one else but the banks could either create them or provide the financial backing for them.
Carter explained: "Take an inflation swap, which is part of the process of moving a pension obligation into the capital markets: some bank or banks will have to be a counterparty to that for - in the case of a pension fund - 60 or 70 years. You can't do that unless you have a big balance sheet. Asset managers or consultants do not have a balance sheet of consequence to mediate those processes - they can advise on them in the case of consultants, they can execute them in the case of asset managers, [but] they cannot actually be the counterparty."
Taking on the consultants
But while in theory at least these bank-run pension groups pose no threat to asset managers - their risk management services taking the form of overlays and being in general complementary to investment - their presence certainly rankles with the consultancy community. Not only do many investment bank advisory groups offer "consultancy" services, in direct competition to the traditional consultancy players, but a great number of their staff have been recruited directly from the very firms they are now pitted against.
David Blake, director of the Pensions Institute at Cass Business School in London, gave this explanation: "One of the reasons why asset managers and investment banks have felt so frustrated is because the consultants provided actuarial services to the trustees and so knew all about the pension liabilities, but they never shared this information with potential service providers in order to protect their competitive advantage.
"Asset managers and investment banks therefore felt blind when they did get to meet the trustees. If you are trying to propose a new assetliability management solution, how can you do this effectively if you do not know the structure of the trustees' liabilities? Over time, the asset managers and investment banks realised where their weaknesses were: they didn't have any actuarial expertise and they didn't have the contacts the consultants had, so, because they can offer higher salaries than the consultancy firms ever can, they started to poach their best consultants."
In other words, the banks realised they needed people with a consultancy pedigree to get a foot in the door with the trustees - the ultimate decision makers - of the defined benefit pension schemes they were targeting. BNP Paribas' New York-based Americas pension desk, which sits within the Global Risk Solutions Group, is a case in point. Co-headed by former Mercer investment consultant Jim Johnston and former Buck Consultants actuary Eric Palley, the desk was set up in March this year.
Speaking of his personal motivation to make the leap from consultancy to sell-side solutions, Palley was frank: "For me it was a combination of things. One was the continuing commoditisation of the consulting field - large parts of what consulting firms do has become commodity work in terms of doing valuation and compliance work for their clients (…) and the way that the DB pension universe has been moving, driven by regulations and everything else, there's really, in my mind, not that bright a long term future for that. The solution everybody's coming up with [in the US] is freeze your DB plan and go to DC - that doesn't leave a heck of a lot of work for the consulting world out there.
"That being said, where I was sitting inside of the consulting world and doing strategic asset allocation studies was one of few growth areas within the field, but I didn't see it as being as interesting - and potentially as lucrative - as doing it within a banking environment." For Palley, it is essential the investment banks do not try to usurp the consultancy industry, but rather work with it to approach pension funds. "Where I think the banks have failed thus far is in being able to communicate the characteristics of what they're selling within the framework the consulting community is used to working within."
Expectation bigger than reality?
With their apparently bottomless balance sheets, expertise in all things financially engineered and raids on the consultancy community, investment banks would seemingly be placed to take the DB world by storm. However, questions have been raised by some onlookers over how much actual business they are seeing.
Con Keating, analyst at pension fund insurance vehicle Brighton- Rock Insurance, stated: "Every investment bank you care to think about now has a pension and insurance group and they're all going out there and offering longevity bonds and LDI, but when you get down to it, there just aren't very many of the pension schemes they all thought were going to be lapping this stuff up [actually] buying into the story."
In fact, Keating stated he believed the industry was in aggregate net deficit. One reason for this, he suggested, was that the "solutions" offered by the investment banks might have rather pre-empted - and in some cases dwarfed - the actual "problems". Keating explained he knew of one defined benefit trustee who claimed to receive regular calls from the pensions groups of investment banks wanting to come and talk to him about "solutions to his problems" - the irony being that his "problems" just aren't on the scale envisaged by these people.
"I think a lot of the problems are perceived rather than real," stated Keating. Fees have also been mentioned as a sticking point. Structured products don't come cheaply and with fees for synthetic exposure being paid for on top of the management fees for investment in regular hard assets, the costs soon mount up for pension funds.
However, while pension funds may not have beaten down the door to the investment banks as yet, the mood inside the pensions groups remains upbeat - the banks are playing a long term game. Said Hari Achuthan, a US-based director in Credit Suisse's Pension Strategies & Transition Management Group:
"The scenario is no different than transition management, where years ago you had pension funds dealing more with indexers and custodians and now you're seeing pension funds work with the broker/dealer community. We think they're a lot more comfortable with investment banks than they were three or five years ago and this trend is rapidly developing across the plan sponsor cimmunity globally.
"I would say the role of a pensions solutions group is going to become more critical, as there are a lot of dynamic and efficient ways of managing assets and liabilities." Achuthan said pension funds might want to consider opportunities in the credit markets in the future and also pointed to a time when investment banks might become the link enabling the matching of assets between the insurance industry and pension funds.
"I think a few years down the road one could see plan sponsors increasingly managing returns using volatility buckets instead of traditional asset allocation strategies," he said.
Johnston and Palley of BNP Paribas, some of the newest entrants to the market, are similarly optimistic about their business prospects. "I see bright blue skies out there," said Palley. While they haven't actually seen a trade as yet, they described the reception they have been given by pension funds and consultants alike as "strong" and explained their expectation when setting up the pensions desk was that it would be a year to 18 months before they actually did any business.
"One of the questions we get typically when we go out and talk to prospects is, 'Well, who's done this before?'" said Palley. "Once there is a public mainstream that is doing these kinds of trades - and not just the mega-sized plans that are terribly sophisticated - that barrier's going to get broken down and people are going to be more comfortable with the idea."
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