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The opdu Report - Issue 20, June 2006 I wonder how many of you remember the banking world in the 1980s. It was a tumultuous period best remembered perhaps for the emergence of the junk bond and a new aggressive style of business culminating in the UK in the ‘Big Bang’ and captured in the minds of many in The Bonfire of the Vanities which in many ways is a shame. Junk bonds were a profoundly democratising development that opened access to the wider financial markets to companies hitherto outside the select band of investment grade institutions. The very name ‘junk’ is a misnomer, since for the vast majority of commercial companies even ‘junk’ bond issuance is beyond their wildest dreams. What does this have to do with Pensions twenty years on? Well, we are working through a phase in which pension promises made by a very wide range of commercial companies in this country are having to be delivered. The term pension promise suggests a certainty of performance which is very high and perhaps the nearest immediate intuitive comparison is the deposit with a major bank which most people would consider their benchmark for security. Banks in this country are solid investment grade being ranked AA or occasionally A. I suspect the unweighted model grading for UK pension plan sponsors is B, just possibly BB. In essence the pensions ‘crisis’ is this mismatch of investment grade certainty being sought from a large number of sub-investment grade sponsors. The way this circle was being squared was, of course, the pension plan assets themselves which in essence collateralise the pension promise. The combination of demographic maturity within many funds and weak investment performance of the fund assets has, however, highlighted a basic banking truism. It is rarely good business to lend solely against the value of collateral in disregard of the underlying credit quality of the borrower. The Regulator is, correctly in my view, advising pension trustees that they should think of themselves as unsecured lenders to their sponsors where there are fund deficits. What is not yet sufficiently stressed is that even where schemes are in ‘balance’, the trustees have significant contingent exposure on the plan sponsor unless there is a very large valuation surplus. This is because the impact of even small assumption changes on a 60 year or more financial plan is huge. When Kipling warned us of the ‘twin impostors’, he was presumably thinking of 95 and 101% funding ratios. It is often said that if you owe the bank £100 you have a problem but if you owe £1billion the bank has a problem. I think you can restate this proposition in terms of time. If you are paying your way now yet possibly owe significant amounts of money forty, fifty or sixty years out then it is the bank that needs to think hard about its position. Pension fund trustees are going to learn a great deal about long term relationship management. Roger Booth
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