Risk management in times of financial crisis


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Risk management in times of financial crisis

  1. 1. September 2008 Risk management in times of financial crisis
  2. 2. Risk management in times of financial crisis Shock bank failures and insurance company rescues. High stock market volatility. What does it all mean for pension schemes? This bulletin concentrates on the potential issues for UK pensions In dramatic times, dramatic action may be necessary to mitigate against major risks schemes, particularly occupational – those who fail to take such action could find themselves in significant difficulties, pension schemes. Clearly, many with capital lost or tied up in all the wrong places. Equally, there are times when similar risks apply to businesses the right thing to do is nothing. and individuals. The note covers issues that are relevant both from a Those responsible for managing pension schemes should act now to identify your trustee perspective and from the risks, ensure the key stakeholders – eg trustee and company boards – are aware of perspective of sponsoring them, and identify and implement any appropriate mitigation. Be aware that some employers. It only covers the risks actions may be, or may quickly become, time critical. associated with shock financial events – clearly all the usual risks of running a pension scheme continue to apply and should be Financial turbulence managed in the usual way. We make recommendations on next Recently we have seen events unfold that would have been close to unthinkable just steps in the final section. a year ago. Some of the world’s biggest banks and insurers such as AIG, Lehman Brothers, Bear Stearns and Washington Mutual have collapsed, or had to be rescued. • What does this mean for the wide range of investment products that are available to pension schemes? The credit crunch • What does this mean for insurance products, including annuities? What would The “credit crunch” refers to the happen if a large insurer was allowed to become insolvent? overall economic events of the last year, but primarily describes the significant loss of confidence that • Does this mean that a large retail bank might fail, and what are the implications financial institutions have had in if it did? each other since about mid-2007. This lack of confidence has led to In the light of the above and other events, investment markets are likely to remain their reticence to lend money to highly volatile and there is the possibility of further shocks to the system, including each other – and maybe rightly so, further failures of financial institutions, entering a recession, significant further as banks began to realise their increases in inflation and large changes to interest rates. For the time being at least, potential exposure to losses arising none of these can be ruled out, even if you think the chances of them are small. from a severe down turn in the US and UK housing markets. So at times like this how do you respond? If you do nothing, you may be running some very large risks, and it is easy to see scenarios where the consequences could be material and trustees could be subsequently criticised for their lack of action or Many banks and other financial their inappropriate actions. On the other hand, there is clearly potential to target institutions rely heavily on their limited resources in the wrong places. ability to borrow money in order to operate and demonstrate their solvency. Consequently, a number of financial institutions have struggled to demonstrate that they can remain solvent and have needed rescuing by other businesses or governments. Given the global, complex and inter- related nature of the world’s financial systems, the knock-on impact of such events has been wide ranging. Until confidence and stability returns, there is a material risk that further financial institutions could get into trouble and/or fail, threatening the smooth running of the world’s financial systems. View a full list of our services on our website – www.lcp.uk.com Page 1
  3. 3. Risk management in times of financial crisis Top 10 tips We have seen a series of financial shocks, with no Prepare a list of your key third party exposures – banks, investment reasons to be confident that 1 managers, insurers etc. Identify the ultimate group company in each case. the latest will be the last. There are also longer term If you believe there is a chance that your scheme’s money on deposit impacts that may emerge over could be at risk, start the process of setting up an alternative account the next few years. By taking 2 with another bank as soon as possible, as the process is likely to take proportionate steps now, and weeks rather than days. acting in a timely way as events unfold, the effect on Check that all banking and investment authorisations and signatories are up-to-date to ensure that actions to divest/invest can be completed your members, trustees and 3 swiftly if needed. sponsoring employer can be minimised. Although this Review all standard transaction procedures for buying/selling assets bulletin is centred on pensions, such as automated switching from one asset class to another; ensure that you may also want to consider 4 they remain appropriate in times of market volatility and illiquidity, and that what aspects of it also apply to processes are in place to ensure that they are followed. other parts of your business. In many cases, the immediate Consider the extent to which material transactions are likely to arise in actions listed here will be 5 the coming months and consider whether any should be deferred or phased. appropriate. Add an agenda item to the next trustee meeting to consider the risks and agree what actions may need to be taken. In particular, we recommend that trustees should update their risk register and in so doing actively 6 reconsider the potential implications of the credit crunch and recession on their sponsoring employer’s covenant; if it is believed that the implications could be material to the pension scheme and the security of members’ benefits, then decisions should be taken as to how to respond to this. Ensure that business planners and finance departments are aware of the potential consequences of falling asset values on year-end company 7 balance sheets and next year’s pension charge and also the potential significant increase in cash contribution requirements that may arise from any upcoming scheme funding valuation if conditions do not improve. If your business suffers redundancies and so there are key personnel changes, consider the impact of these on your scheme’s finances and 8 ensure adequate continuity for key roles, such as trustees and pensions staff. Watch out for notifiable events – ie events such as credit rating 9 downgrades and breaching banking covenants - that may need to be reported to the Pensions Regulator at the earliest opportunity. To the extent appropriate, communicate to members to allay any concerns 10 they may have about the sponsoring employer, or about events in the financial world more generally. View a full list of our services on our website – www.lcp.uk.com Page 2
  4. 4. Risk management in times of financial crisis Keeping everyone informed In all cases, it is important to ensure that the appropriate people are aware that risks exist and, if possible, that action is being taken to mitigate them. Members Pension scheme members may be unnerved by reports of a weakening employer covenant, falling asset values, or wider events in the economy. The trustees and employer may wish to communicate to members to assure them that they are aware of the risks and mitigating actions are being taken. Management time may be needed to deal with queries and specific concerns. Trustees Trustees need to be kept informed. Where appropriate, urgent meetings may need to be called and sub committees may need to be set up at short notice to deal with urgent matters. Companies will need to work to maintain a strong relationship with trustees, amid other corporate distractions. Trustees also need to keep an open dialogue with their sponsor, as some changes will require consultation. Trustees should also keep clear records of decisions, so that they can be justified when considered in retrospect. Management Those with responsibility for pensions within an organisation should consider the extent to which management and company boards should be kept abreast of matters. Key individuals may need to be reminded of legal duties to consider the appropriate involvement of trustees in material corporate change. View a full list of our services on our website – www.lcp.uk.com Page 3
  5. 5. Risk management in times of financial crisis What can happen in times of financial crisis? Before looking at the consequences for pension schemes, in this section we list a number of possible consequences of the ongoing credit crunch itself. Whilst just a year ago many of them would have been next to unthinkable, some of the most unlikely have indeed already happened. • Possible failure (or rescue or partial rescue) of an investment bank, a retail bank, a building society or an insurer. • Flight to quality – government bonds and gold prices may soar, with long term yields on government bonds falling, whilst prices of other, more risky, investments may fall significantly – including equities, corporate bonds and property. • Normal trading rules may temporarily cease to apply – assets that are normally highly liquid may become unpriceable and / or untradeable (or tradeable but with associated transaction cost being sky high) and therefore may essentially “Risk management has become illiquid for a period of time; stock markets may close for periods and been a key theme for market volatility may be extremely high. pension funds for several years now. For many • Commercial contracts may be tested to the limit as businesses struggle to pension scheme trustees, survive or fail – counterparty and collateral contracts for some investment this could be the first time products may be at risk of failing. that your risk management framework will really be • Underlying economic data may change quickly and significantly – eg inflation put to the test.” may take off or fall sharply, interest rates may be adjusted significantly and without warning, unemployment may materially increase. Aaron Punwani • Businesses may hold onto cash, may make many people redundant, may close down operations and subsidiaries or fall into receivership – some of these Head of LCP events may occur suddenly and without warning. Trustee Consulting • Group parent companies may get into financial difficulties and may seek to move money out of local businesses and subsidiaries; trustees must be alive to these issues. • Generally, employees and directors are likely to be under more pressure from management and shareholders to identify risks, report them immediately and take urgent mitigating actions. Business risks may be just as likely to arise from over-reaction as from inaction. View a full list of our services on our website – www.lcp.uk.com Page 4
  6. 6. Risk management in times of financial crisis Sponsor Investment strength Accounting for Managing pension schemes through financial crisis Funding pensions and issues internal There are clearly numerous possible consequences of the above events on pension schemes and it compliance would be impossible to identify all of them. In this section we highlight some of them, but perhaps Banking and Insurances the most important thing is to always be aware that unexpected consequences could arise, and be ready cash flow to take any necessary action. Benefits PPF Issue Description Comment Possible actions Investment Asset value The value of a pension fund’s assets may fall, and may fall This demonstrates the Material falls in asset values may significantly over a short period of time. The timing of this importance of choosing an make it appropriate to conduct an falls may coincide with reporting dates, eg for scheme funding appropriate investment urgent review of investment valuations, company accounting or reporting to members strategy, being aware of the strategy, particularly if the (these points are expanded below). Some particular equities extent of the risks for the fund sponsoring employer’s own or bonds in the portfolio may literally become worthless. and for the sponsoring financial strength has also changed employer, and the materially. diversification of assets generally. Counterparty Some investments rely on a “counterparty”, eg stock Lehman Brothers was a Be aware of the risks that you lending, many liability driven investment portfolios, counterparty to some are exposed to. Identify the risk including interest rate and inflation swaps, and other investments used by UK counterparties and ascertain who derivative based investments, including equity notes, pension funds. their group owners are. currency trades and longevity derivatives. Such investments are often further protected by “collateral”, ie transfer of ownership of actual assets equal to the face value of the investment, the amount of which is adjusted daily. If counterparties fail, then losses may occur, and other risks and losses may arise during the period that collateralisation ceases to function. Buyout and In the week of the 15th September 2008, insurers were The plight of AIG has Trustees who are considering a finding it impossible to price annuities because of illiquid illustrated that a very large buyout should carefully consider annuities markets. For the time being, many of them have stopped annuity insurer, with a the balance of the risks they are offering guaranteed prices. Some insurers may have diversified portfolio and an eliminating versus the new risks exposure to sub-prime losses. All have exposure to a exceptional brand, can fail, or they are taking on, and make wide range of other financial organisations. need to be rescued. informed decisions. Trading risk Pension funds routinely buy and sell assets. This may be In times of market illiquidity, particularly relevant when there is a large cash flow in or volatility and high transaction out of the fund (eg a special contribution, transfer from costs it is appropriate for another fund) or the investment strategy is being adjusted, trustees to consider whether the perhaps following an investment strategy review, or “normal” procedures should still implementation of previously agreed de-risking, or simply be applied, perhaps choosing to to maintain the agreed strategy of having a fixed delay or phase certain percentage in a particular asset class. transactions, and ensuring that any period of time “out of the market” is kept to a minimum. Investment In times of market shocks and volatility it can be expected Be aware of the risk of that investment manager performance may throw up underperformance and monitor management surprises. For active managers, the impact of being more closely than in normal performance underweight or overweight in financial stocks (for circumstances. example) could have a very significant impact on their performance. For passive managers, material divergence from their index may become more likely as they struggle to “keep up” with market changes. Derivatives The value of derivatives type contracts, that are held to Be aware of the exposure to create synthetic or more efficient exposure to underlying such contracts and keep a assets, eg credit default swaps in place of physical register of them. corporate bonds, may not behave as expected. This could be either due to small changes in the pricing basis, or due to the legal nature of the contract. Other third Brokers, advisers and custodians may each be at risk of Redundancies may lead to a Be aware of your exposure to third failure, or having assets tied up. change in relationships, parties and maintain appropriate party failure perhaps at a time of crisis. relationships with them. Issuing Instructions to investment managers or banks need to be There is a risk that a problem Review authorisation and issued in a timely manner. There may be the risk that is only discovered at a time signatory lists to check they are instructions instruction protocols, eg authorised signature lists, are not when a transaction needs to up-to-date. in place or up to date. be completed very quickly. Page 5
  7. 7. Issue Description Comment Possible actions Sponsor strength Changing The strength of the employer’s covenant to a Companies should be Trustees need to remain pension scheme may reduce materially, or the proactive in engaging with vigilant in closely monitoring covenant employer may become insolvent. Where the trustees ahead of major a company’s strength and strength of the employer has materially changes. taking mitigating action diminished, or is at more risk of materially sooner rather than later. It diminishing, trustees should consider urgent may be appropriate to seek mitigating action, for example using the special meetings with powers available to them within their rules, management to discuss the seeking additional contributions or contingent covenant, to seek additional assets (perhaps by triggering a valuation), or information, to appoint switching to more secure investments. financial advisers and/or conduct a special review of the covenant. Unusual events At times of financial crisis, management may Normal procedures may not Trustees need to keep close make quick, unexpected decisions which may be followed in extreme to the action and perhaps have significant financial consequences. A circumstances and events request to be kept closely in group headquarters may put pressure on UK may develop very quickly. the loop if they are aware that subsidiaries to pass cash further up the group. their sponsoring companies A business, subsidiary or key assets may be are under pressure. acquired by new shareholders or moved elsewhere within a group. Notifiable Changes in credit rating, breaches of banking There are some exemptions Be aware of requirements and covenants, changes of control and changes to from this. ensure compliance. events directors or other key posts, can all be events that the employer must generally notify to the Pensions Regulator as soon as possible. Change in In practice, one of the most challenging It is important for all parties consequences of financial crisis can be the to make urgent efforts to personnel speed at which personnel and relationships build new relationships change. Experienced trustees can be made between the key decision redundant and may need replacing quickly so makers if personnel changes that the trustee board can cope with the happen at a time of financial pensions issues. Key management personnel, crisis. who have had experience of the pension scheme and long standing relationships with the trustees and their advisers, may be diverted to other management responsibilities and have no time for pensions, or may be made redundant. Financial In times of stress, people can be tempted to For example, if trustees are Be vigilant. act inappropriately. aware that an employer is in irregularities financial difficulties and and fraud there is a delay in paying an employer contribution to the scheme, this should trigger more urgent action than in normal circumstances. Page 6
  8. 8. Issue Description Comment Possible actions Funding issues Increased Material increases in deficits may trigger the need The trustees’ response will Trustees may need to for an out-of-cycle actuarial funding valuation and be dependent on the consider if such action is deficits a request for additional contributions (or a strength of the employer’s appropriate. demand for such contributions if the trustees covenant. have that power under their rules). Currently Where valuations are currently being completed, Trustees may need to the trustees, the company and the actuary should consider if such action is ongoing consider the extent to which it is appropriate to appropriate. valuations take into account “post valuation date” events. Transfer values Increased deficits and changes in investment There may be a need to Trustees may need to strategy could lead to a need to review the basis reduce transfer values in consider if such action is for setting transfer values. respect of underfunding in appropriate. the scheme. Accounting for pensions & internal compliance Increased Material increases in FRS17 and IAS19 deficits This may have a very Companies may wish to may emerge before the sponsoring employer’s significant impact on the consider the potential deficits and next year-end. company’s balance sheet impact on their accounts, profit charges and on the following year’s the perceptions of their pension charge to profit. shareholders and other investors including banks, and the impact for 2009 budgeting. Funding vs In times of financial crisis, it should be expected Management and Companies who comply that pension fund liabilities measured for different shareholders may be with International GAAP may accounting purposes will diverge. In particular, trustee surprised to see the need to book additional funding valuations are likely to show much higher combination of very high liabilities on their balance deficits than those revealed under FRS17 or contribution demands from sheet as a consequence of IAS19. This is because gilt yields (which drive trustees, but less damage the new IFRIC14. The funding valuations) remain low, whilst corporate shown in the accounting expectations of senior bond yields (which drive accounting valuations) figures. management and investors increase significantly – this simply reflects the may need to be managed, “flight to quality” within investment markets. with the consequent communication issues that arise. Compliance Each company will have its own set of internal It is likely that these rules It will be important to follow, rules to follow for compliance purposes, will be tested in extreme or amend the rules as potentially based on Sarbanes Oxley. financial conditions. appropriate. Page 7
  9. 9. Issue Description Comment Possible actions Banking and cash flow Bank failure If a UK bank fails, it is quite likely that someone It is very unlikely to be associated with the pension scheme will bank appropriate to pay any with them. This could be the employer, the money to a failed bank. trustees, members, or any other third party. This may involve swift action to, for example, interrupt a pensioner payroll run. Diversify Trustees may wish to consider diversifying their It may be appropriate to do banking facilities away from banks that are the ground work on setting perceived to be relatively more risky, especially if up new bank accounts the trustees routinely hold a material amount of sooner rather than later, as cash in the bank. this can take time (eg due to anti-money laundering requirements). Insurances Insurance Pension schemes may have a number of It is likely to be appropriate insurances, from life insurance and annuities to to cease paying premiums company failure trustee indemnity insurance. The employer may immediately to a failed also have related employee benefit insurances, eg insurer, although advice income protection, special insurances for senior should be taken in that management. If an insurer fails, claims may not event. Insurances may need be paid, but benefits may have been promised to to be re-arranged with other members. insurers very quickly in order to mitigate against further risks. PPF Increased Individual levies and possibly the overall levy in Action now may help to 2009/2010 could be significantly higher. This may mitigate the PPF levy. levies arise because of increased deficits in pension schemes and/or the PPF deciding that they need to significantly increase the total planned levy (£700m in 2008/09) because of the increased risk of insolvencies generally and because the PPF’s own assets have fallen in value. D&B scores Sponsoring employers’ D&B scores at 31st March A material worsening in Action now may help to 2008 are due to be used to set the 2009/2010 individual D&B scores can mitigate the PPF levy. levy. Changes to D&B scores before 31st March have a very geared impact 2009 can be expected to impact on 2010/2011 on levies. levies. Page 8
  10. 10. Issue Description Comment Possible actions Benefits DC investments The value of members’ DC funds may fall Members are likely to be Understand the risks within considerably. Complications could arise if the concerned about this. your DC funds and consider investment manager / insurer becomes whether any communications insolvent. Complications could arise if DC are appropriate. funds are exposed to derivatives and/or counterparty risk. The performance of passively managed funds may diverge from their index. Actively managed funds may perform particularly badly or well. Redundancy Members may lose their jobs. Perhaps the It is possible that some Ensure that HR managers are worst combination is if members in their early members have not fully aware of the issues. and DC 50s lose their jobs and need to draw on their understood how their fund pension. Many such members will still be was invested and the invested 100% in equity related assets, having meaning of terms such as not yet entered the protection of lifestyle “lifestyle”. switching, and fund values and their consequential retirement income could therefore be very low. On-going nature Tough times can lead to tough benefit Some of these may require Cutting back of accrual, decisions being taken by companies, in formal member consultation redesigning benefits and of the scheme discussion with the trustees. before they can go ahead. liability management opportunities may all be considered at these times. Inflation and If inflation takes off, any caps on pension This may take some Take early steps to increases may apply – eg 5% or 2.5%. pressure off funding, but appropriately manage the pension there may be pressure from expectations of all parties. increases pensioners for discretionary pension increases as their standard of living falls. Transfer values In times of high market volatility, there are risks For example, being out of Ensure procedures are associated with members being “out of the the market on 19th appropriate and are followed, market” between transferring from one September 2008 could have and members’ expectations pension scheme to another. cost a member nearly 10% are managed. of their pension savings. AVC and other Likewise, there is a risk at retirement if Ensure procedures are members’ DC funds are disinvested at an appropriate and are followed, DC benefits and inappropriate time. Annuity prices may also and members’ expectations retirement change significantly from one week to the are managed. next. Page 9
  11. 11. About LCP Lane Clark & Peacock LLP (LCP) is a limited liability partnership and offers a full range of actuarial, benefit consultancy and risk services to clients in the UK and internationally through LCP Trustee Consulting, LCP Corporate Consulting, LCP Financial Dynamics Practice, LCP Insurance Consulting and LCP Investment Consulting. The LCP Trustee Consulting practice focuses on providing advice on pensions issues that are of concern to trustees, such as governance, implementing the new pension scheme funding regime, assessing the adequacy of contribution plans, advising on investment issues, assessing the strength of the employer covenant, and advising on the issues surrounding insolvency and the winding up of pension schemes. The LCP Corporate Consulting practice specialises in advising companies on how best to manage their pension schemes’ finances through contributions, investment policy and other approaches. The practice also advises companies on how best to manage the impact of their pension schemes on company finances, how to represent pension schemes in company accounts, ensuring that UK and international benefit plans attract and retain employees effectively, and managing benefit issues in mergers and acquisitions. The LCP Financial Dynamics practice specialises in offering a new dimension to risk appraisal, business modelling and valuations of companies. The practice uses advanced financial models to give companies a competitive advantage when considering business decisions. The LCP Insurance Consulting practice provides specialist actuarial advice in the field of insurance and reinsurance. The practice also advises on wider risk management issues for insurance organisations. The LCP Investment Consulting practice specialises in advising both corporate sponsors and pension scheme trustees on the appropriate investment policy, as well as on the broader areas of risk management. The practice is able to identify the potentially complex and conflicting needs, explain clearly how to address those needs and help with the implementation of the chosen solution. LCP employs more than 500 staff including over 200 full and part qualified actuaries. We serve a wide range of clients around the world, including some of the largest global multinationals, such as Pearson, Volkswagen and Whitbread. We also serve a number of private equity houses, charities and unions. If you would like assistance on any of these issues, please contact the partner who normally advises you, or call Aaron Punwani on +44 (0)20 7439 2266, Jonathan Camfield on +44 (0)1962 870 060 or Ken Willis on +44 (0)20 7439 2266. This bulletin is generic and should not be relied upon as detailed advice. LCP accepts no liability for any action taken on the basis of this bulletin unless you have requested that we provide specific advice to you and we have done so under our usual terms of business. This bulletin should not form the basis of any investment decision. Page 10
  12. 12. FT Business Pension & Corporate Adviser Awards UK Professional Pensions Awards Investment Provider Awards Best Member Communication Strategy 2008 Actuarial Consultancy of the Year 2005 | 2006 | 2007 Actuarial Consulting 2007 | 2008 Best use of Technology by a Corporate Adviser 2008 Investment Consultancy of the Year 2007 Investment Consulting 2007 | 2008 Best Strategy for Investment Advice on Pensions 2009 UK UK Belgium Ireland Jersey Netherlands Switzerland Switzerland Lane Clark & Peacock LLP Lane Clark & Peacock LLP Lane Clark & Peacock Lane Clark & Peacock Lane Clark & Peacock LLP Lane Clark & Peacock LCP Libera AG LCP Libera AG Belgium CVBA Ireland Limited Netherlands B.V. 30 Old Burlington Street St Paul’s House * Oriel House Stockerstrasse 34 Aeschengraben 10 London W1S 3NN St Paul’s Hill Marcel Thirylaan 200 Office 2 York Lane, St Helier “Galghenwert” (9th floor) Postfach Postfach Tel: +44 (0)20 7439 2266 Winchester Avenue Marcel Thiry 200 Grand Canal Wharf Jersey JE2 4YH Herculesplein 40 CH-8022 Zürich CH-4010 Basel Fax: +44 (0)20 7439 0183 Hampshire SO22 5AB B-1200 Brussel South Dock Road Tel: +44 (0)1534 887 600 3584 AA Utrecht Switzerland Switzerland Tel: +44 (0)1962 870 060 Bruxelles, Belgium Dublin 4 Ireland Fax: +44 (0)1534 837 888 Netherlands Tel: +41 (0)43 817 73 00 Tel: +41 (0)61 205 74 00 Fax: +44 (0)1962 849 802 Tel: +32 (0)2 761 45 45 Tel: +353 (0)1 614 43 93 Tel: +31 (0)30 256 76 30 Fax: +41 (0)43 817 73 99 Fax: +41 (0)61 205 74 99 Fax: +32 (0)2 761 45 46 Fax: +353 (0)1 668 63 03 Fax: +31 (0)30 256 76 31 * No regulated business is carried out from this office All rights to this document are reserved to Lane Clark & Peacock LLP. This document may not be copied or used in any way without prior permission from Lane Clark & Peacock LLP. A member of the Multinational Group of LCP is a limited liability partnership registered in England and Wales with registered number OC301436. LCP is a registered trademark in the UK (Regd. TM No 2315442) and in the EU (Regd. TM No 02935583). Actuaries & Consultants. www.mgac.org All partners are members of Lane Clark & Peacock LLP. A list of members’ names is available for inspection at 30 Old Burlington Street W1S 3NN, the firm’s principal place of business and registered office. Main offices in: AFRICA AUSTRALIA The firm is regulated by the Institute of Actuaries in respect of a range of investment business activities. LCP is part of the Alexander Forbes group of companies, employing over 4000 people internationally. EUROPE AND NORTH AMERICA www.lcp.uk.com www.lcpeurope.com UK c0908/0509