Why Are Companies Rejecting Buyouts (Even When They Can Afford It)?

(August 16, 2012) — Companies listed in the United Kingdom are channelling an average 12.5% of cash generated by core activities each year to plug funding gaps in their pension funds, despite many having the money to de-risk.

Over the past three years, deficit contributions to defined benefit (DB) pension funds have consumed four and a half months’ worth of cash generated by the largest 350 listed companies in the UK, consultants and actuaries Barnett Waddingham said this week. This equated to the cash generated by core activities for one and a half months each year being spent to try and close the pension funding gap.

These extra payments were made despite almost a quarter having enough cash holdings at the end of 2011 to de-risk their pension fund through a buyout structure, Barnett Waddingham said.

“Despite the significant level of contributions, DB scheme deficits remain a concerning issue,” said Nick Griggs, head of corporate consulting at Barnett Waddingham. “Many companies continue to take a longer term view on the funding and investment strategy for their DB scheme. This is evidenced by the investment risk being taken and the number of companies that have increased their cash holdings to a level which might allow them to realistically consider a full scheme buy-out, which so far they have chosen not to do.”

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Barnett Waddingham found that 24 of these 350 companies could have afforded a buyout solution with the cash generated in 2011 alone.

Companies and their pension boards may have been distracted by market movements that appear alien to many. Barnett Waddingham said for 80% of companies, changes in real yields had become a greater source of volatility than equity market movements.

Equities have seen a relatively calm period over the last couple of months, despite on-going market turmoil. The index monitoring equity market volatility – the VIX – hit five year lows this week after pushing up a little at the end of May. These numbers have been markedly down on the same period last year when the VIX spent weeks at record high levels.

Year-to-date, the MSCI World Index is up 7.97%, and has displayed a relatively smooth trajectory, save a blip at the end of May.

Conversely, real yields have been on the move – in a downwards fashion – more than many corporations would like. The drop has also hit pensions twice as liabilities and portfolio returns have both been impacted.

Steve Collins, head of dealing at boutique fund manager London & Capital, said: “In the UK, due to the powerful combination of quantitative easing and low nominal GDP growth, real yields, remarkably, are now negative for maturities up to 20 years.”

It is against these yields that actuaries need to discount existing liabilities.

Collins concluded: “The move to negative real yields has created a lot of volatility in the calculation of these liabilities, effectively saying the value of future pay-outs is higher than the value today – This is quite a problem for pension schemes, and it isn’t going away for some time to come.”

Massachusetts’ public pension system is in the midst of a massive asset shift from funds-of-funds to direct hedge fund investments, and Board Chair Steven Grossman is very happy about it.

(August 16, 2012) — The Massachusetts’ public pension system is adamant about directly investing with hedge funds—and its initial foray into the strategy has been an unqualified success.

“All indications so far say it was the right thing to do,” Board Chairman and State Treasurer Steven Grossman told aiCIO. “It’s going well—we’re steadily moving funds. Certain assets we can get at right away, others we have to wait.”

The Massachusetts Pension Reserves Investment Management Board (MassPRIM) is just over a year into the process of pulling out nearly all of its funds-of-funds investments, cutting ties with most of those asset managers, and reallocating those assets directly into hedge funds. At this point, Grossman estimated, about 60% of MassPRIM’s hedge fund allocation is directly invested, with the target being 85%. Pacific Alternative Asset Management Co. (PAAMCO) takes the entire remaining 15% for funds-of-funds investments heavy on emerging managers. “That’s an area we want to broaden our outreach to, and we’re doing that through PAAMCO,” he said.

“We were paying an extra 84 basis points over standard direct management fees on our funds-of-funds investments,” said Grossman. “On $5 billion, that’s $36 million. We hadn’t been particularly happy with our returns on those investments. And with funds-of-funds, they do the due diligence, and we’re simply more comfortable doing it ourselves.” Given all of these factors, the $48.8 billion fund’s board “carefully, thoughtfully decided to make the move.” And move it did.

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MassPRIM started with a $500 million pilot project to work out the legal and logistical kinks involved in withdrawing the equivalent of Barbados’ GDP from roughly 200 illiquid investments. “We wanted to test everything out first, and make sure we knew all the details before going ahead with it,” explained Grossman.

Cliffwater, MassPRIM’s advisors for this whole process, concluded that optimal diversification could be reached through direct allocations to roughly 20 hedge funds, as opposed to the more than 200 indirect, often redundant, funds-of-funds investments MassPRIM had been dealing with (and paying for).

And now, a little over a year into the process, what’s the verdict? “You might as well own directly, get close to the source, keep due diligence internal, and save $36 million,” Grossman said. “We’re looking forward to cutting out the middle man and working closely with a group of 20 or so hedge funds that we’ve selected ourselves.”

Note: An earlier version of this story mistakenly cited PIMCO instead of PAAMCO as the sole remaining fund-of-funds investment.