Up, Up and Away
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Few people would have thought the somber days following the terrorist attacks on September 11, 2001 would have provided Rolls-Royce, one of the largest manufacturers of aircraft engines in the world, with the impetus to become a stronger company. But it did. How? The sudden collapse of share prices all across the aviation industry brought one of the items on Rolls-Royce’s balance sheet hurtling into view and company bosses were compelled to tackle it decisively.
“After September 2001, Rolls-Royce found itself facing a pension deficit bigger than the market capitalization of the company,” said Iain Foster, who was one of the architects of the company’s liability-driven investment (LDI) program. Foster now works in mergers and acquisitions for the engineering firm, but in 2001 he was in the Treasury department. “Rolls-Royce has a very long history, so the number of pensioners outstrips the number of employees.”
For this reason, the pension fund had always been large relative to the size of the company, but in 2001 it was becoming unmanageable.
In June 2001, Rolls-Royce shares had been trading on the London Stock Exchange for up to £2.50. In the week after September 11, they were trading at less than half of that, hitting a low of around £1.20.
Of course, this slump was no reflection on the company—engines were being made to the same exacting standard they had always been—but the environment in which they were operating had changed.
“Our customers in the aviation industry were struggling,” said Foster. “Our share price was down and we were downgraded by rating agencies, too.”
Ratings agencies were concerned about the company’s revenue streams as airlines, hit by passengers’ fear of flying and insurers’ fear of paying out, scaled back plans for expansion.
In 2002, Rolls-Royce’s revenue from Civil Aerospace—its largest business segment—fell 20%, according to annual reports. It would take another three years to climb back to 2001 levels, but not before its share price dipped as low as 69p in March 2003.
Economic distress was not the only problem, however.
“At the turn of the millennium the rules of the game changed,” said Foster. “Following a number of scandals in the 1990s, companies were told to stay away from pension funds—this was to prevent them from dipping in, or being seen to dip into them. In effect, companies and pension funds were viewed as separate entities.”
This move gave more autonomy to trustees, which turned into more power.
In 2001, changes to corporate accounting rules added pressure to companies’ balance sheets. Companies had been implementing SAP24, which used actuarial smoothing and meant assets were not marked-to-market. When FRS17 was introduced, then IAS19, there was a move away from smoothing and liabilities, which were from then on noted on a company balance sheet, and were shown to be very volatile. Not great during the dot-com crash.
In 2004, the UK’s Pensions Act also shook things up: it gave more power to trustees and required companies to look at deficits as they would any other type of corporate debt. Ratings agencies had also started to scrutinize pension funds and consider them when issuing reports.
“The focus of Group Treasury was on pensions: they saw it as a pot of cash that was managed by someone else, but which affected the whole company, including M&A and financing,” said Foster. “Also, many decisions made at a corporate level potentially had to be run past trustees if they could impact its pension fund.”
With all these issues mounting up and against the backdrop of an uncertain short-to-medium term future for the global economy, Mark Morris, Rolls-Royce group treasurer, formed a task force. This team included Iain Foster, assistant treasurer; Gerard Hutchinson, director of reward strategy; and David Colclough, investments manager. Following an internal review focusing on the largest liabilities facing Rolls-Royce and beginning with the UK, advisors were appointed and a strategy formulated.
In 2005, the team started to implement a plan targeting three main areas: benefits, contributions, and investment strategy. “We closed the scheme to new entrants. At the time it didn’t feel like defined benefit funds were something companies could afford to offer anymore,” said Foster. “We slowed the accrual rate from 1/60 to 1/80 and then tackled the investment strategy. We agreed with the logic of liability-driven investing from the start. We wanted to hedge risks that were unrewarded. People buy shares in Rolls-Royce for the performance of the group, not its pension fund. We have engineers throughout the company and in the treasury department we take the same approach with risk management.”
If they were to implement the LDI program, the lower risk investment strategy would imply a lower expected return. The team soon realized there would have to be a quid pro quo and the company would have to put more cash into the pension fund to get approval from trustees. In 2007, the Rolls-Royce board approved the cash injection the team needed to in order to proceed and to reduce volatility in the company’s three biggest UK schemes.
Trustees’ fears for their members were allayed and Rolls-Royce’s LDI program was off the ground.
The trustees chose Legal & General Investment Management (LGIM) as LDI provider while the company had enlisted Goldman Sachs as corporate advisor. Both relationships worked well, and Foster credits them with the successful creation and implementation of the strategy.
The Rolls-Royce plan was to use swaps to hedge out interest and inflation risk and reduce exposure to equities, which made up 80% of its investment portfolio. However, there was a minor obstacle. In 2004, the S&P500 had risen over 9% and the FTSE 100 had risen 8%. These were punchy returns and ones that some on the trustee board were reluctant to lose, given the gaping shortfall in the fund. In 2005, returns were positive again and by 2006 the FTSE100 rose almost 9.5% and the S&P500 was brushing a 12% increase. “Some of the trustees were concerned that by selling equities we would see less upside and make poorer returns from our investments,” said Foster.
This is where the quid pro quo came into play, in the form of a £500 million cash injection split between the three largest UK funds.“Equity performance following the board approval improved the funding level further, providing a real tail-wind. We were all prepared and ready to go in June 2007,” said Foster.
However, in the heady summer days of 2007, equity markets seemed unlikely to dip, so trustees and their advisors contemplated holding off selling the funds’ equity portfolios. Cometh the hour, cometh the then Group Treasurer (now CFO) Mark Morris. He cautioned against waiting for a better time that may not come.
It was at this point that Rolls-Royce’s watch seemed to be in sync with the market.
“There were whispers about sub-prime, so we chose to get out of equities at that moment,” said Foster. “We were told it would take months to liquidate the physical investments, so we put an overlay hedge on the equities portfolios in July to negate their movements. At that stage the FTSE 100 was at 6,500 and it has not been there since. We sold the remaining chunk through October and November.”
The 80% stake in the asset class was reduced to 20%, minimizing equity risk, so it was time to turn to hedging interest rates and inflation.
“We were a big fund—£6.6 billion—and if we went straight to the market to hedge these risks, it would have been obvious from the first transaction that there was a lot more to come. The market was so thin that participants would have easily taken advantage,” said Foster.
So the fund used LGIM’s account and acted as if the fund house was carrying out trades on behalf of its clients in the usual manner.
“It looked like LGIM was just putting on its usual inflation trades,” said Foster. “It has some of the largest volumes in the UK. At that stage there were single digit number of banks trading UK inflation, so we had to be careful. The transactions were carried out over several months.”
Taking their eye off the ball at this stage could have collapsed the entire deal. Moving the rate at which inflation was hedged even by 1% would have amounted to a half a billion pound hit to the fund.
“We got into a discussion with the trustees about using swaps rather than physical assets (gilts)—their consultant didn’t like derivatives, and this was even before they became synonymous with the financial crisis. The main concerns were the counterparty risk and the difficulty in generating LIBOR with the cash assets underlying the hedges. Our stance was that this was a secondary risk that should not delay the hedging of the larger risks and, as long as the investments were delivering more than LIBOR minus 30 basis points (bps), derivatives were cheaper than gilts. At this point it was early 2008 and liquidity was the thing to have, but we had delivered LIBOR by using swaps.”
Foster and the team put all the cash earned from the sale of equities in the summer of 2007 into short-term, cash-like instruments with LGIM, intending to invest them later. By now, most of the risk had been taken out of the fund just as markets were getting jumpy. It was the beginning of 2008 and the credit crunch was looming large. The four strong Rolls-Royce taskforce thought the fund was well positioned, but it was now time to diversify the way the LDI assets were invested.
“We had proposed a portfolio of 30% in very safe funds (gilts) that were producing less than LIBOR, 40% in cash instruments that were producing LIBOR, and 30% in credit producing more than LIBOR. The liquidity crisis then bit and the asset/swap spread reversed for the first time ever. Gilts were yielding more than swaps, so the proposal was amended to increase the amount invested in gilts. Throughout the autumn of 2008 we bought asset-swapped gilts earning up to LIBOR +100bps and some government-guaranteed Network Rail bonds which were yielding 150bps over LIBOR. We had reduced our investment risk significantly and were getting yield pick-up in the process. The problem of how to reliably deliver LIBOR was fixed by the credit crunch: we sold liquidity to the highest bidder.” The actions taken by the team seemed to be prescient in their timing. “The initial decision to get out of equities was great and the interest rate locked in with hedges was looking very healthy,” said Foster. “We were £2 billion in assets up from where we would have been otherwise by the end of 2008.”
By this time the financial crisis was in full flow. Lehman Brothers had collapsed and banks, along with hundreds of other financial institutions, were manically deleveraging and flooding markets with cheap bonds and loans.
Again, at a very timely moment, Rolls-Royce found itself with money to spend on good quality assets at attractive prices.
“At the beginning of 2009 we looked at corporate credit—we wouldn’t take anything less than A-rated—and people were unloading huge amounts of it onto the market,” said Foster. “Moving into credit meant we were diversifying how we made LIBOR+ and were getting away from relying too much on banks as counterparties.”
Cast your mind back to 2008. Everyone was suspicious of everyone else. If Lehman Brothers could go, then another bulge bracket bank could suffer the same fate—and a couple of them looked like they might. Counterparties had to be secure, deals had to be collateralized, and a close watch was kept on both.
The swaps held by Rolls-Royce, put in place a couple of years before the crisis hit, meant the pension fund held large positions with some of the banks that looked shaky.
“We made sure we collateralized daily, while our liability and asset swaps were netted down equally with each bank. We had a position with Lehman Brothers and when the bank went down over the weekend and the UK arm on the Monday, we had closed out our position by the Tuesday for minimal loss.”
With the bulk of the work done, the team had positioned the company to weather the unfolding financial crisis, having done as much as they could to immunize the pension against major risks to its funding. They had not quite finished though. “Once we had sorted out the interest rate, inflation, and equity market risk, other risks that had been hidden by the volatility now became obvious such as longevity and actuarial risk,” said Foster.
In 2011, the team hedged its pensioner longevity risk in a swap deal to last 50 years with Deutsche Bank. Unlike inflation and interest rate risks, which are relatively similar for all market participants, longevity risk is specific to each fund. All the hedges need tweaking when new assumptions are produced and deferred member data changes. Foster is also concerned with potential new regulations on over-the-counter derivatives that could see swaps moved to central counterparties (CCPs), potentially causing headaches for pension funds. But in the grand scheme of things, these are just niggles.
“On an accounting basis we are in surplus,” said Foster, “but it is a nonsensical valuation that based discount rates on assumed future returns without taking defaults into account. At Rolls-Royce, we monitor the funding on a more prudent, low risk/return assumption which implies a small deficit. We can manage the fund on a ‘steady as she goes’ basis for the time being. If there is another market dislocation or the asset/swap spread reverses, then we will crystallize gains again, but there are no more major moves to be made for now.”
It seems the pension fund—and therefore the company—is in a secure position. But Rolls-Royce is in the minority. According to figures from the Pension Protection Fund, the lifeboat for bankrupt companies in the UK, at the end of September just 18% of corporate pensions were in surplus and the average funding level was just over 82%. (It should be noted that the PPF funding basis is stricter than IAS19 accounting standards.)
“We weathered the crisis well and there has since been much focus on our LDI strategy. This reinforces my opinion that every pension fund should still be considering hedging to some extent—even if the fund is only a minor distraction to the company “said Foster. “You have to look at your risks—if you are not being rewarded for running them, you have to ask why you continue to do so. If you don’t hedge, you’re effectively betting the underlying positions are going to move favorably.”
He urged pension funds to be strategic, be macro, and to take a long-term view. “It is up to banks and hedge funds to take advantage of the short-term dislocations. The pension funds can take the macro opportunities.”
Foster, who is now involved in M&A for Rolls-Royce, has also become a pension fund trustee to the largest Roll-Royce scheme. “The pension fund now needs people with experience in derivatives, counterparty risk, and general risk management, given the new investment strategy. The fund now only needs to earn a small margin over the gilt yield to pay its obligations. It is important that we remember where we could have been if we are ever tempted to invest in higher risk strategies again.”
And how about the luck with the timing when some people lost their shirts in the financial crisis?
Well, Foster claims that luck played some part, but fortune favors the well prepared.