The Godfather rule

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How do you turn a one-page article into an impenetrable quagmire of deathly dullness? Well, using the words 'pensions' and 'regulation' in the first two lines gets you halfway. Unfortunately, pension regulatory developments are as important as they are boring. This presents something of a problem: how to engage in the process of understanding the morass of reforms occurring around the world, and then transforming these developments into a compelling read.

A colleague of mine, Marino Valensise, has done a pretty good job in simplifying the whole mess down to one principle that he calls (in his Sicilian lilt) "the Godfather rule". The idea is as follows: you owe the Godfather $100 tomorrow, and if you have the money you pay. But if you only have $10, prudent money-management just isn't going to cut it. The best way to avoid becoming shark bait is to go to the casino and pray that the 10-1 bet comes good. Similarly, pension funds that are fully funded should immunise their liabilities, but those that are not might as well play in the stock market or hedge fund casinos.

There is good evidence that this principle is being applied across the UK: the 10 least well-funded schemes of FTSE 100 companies have on average a full 20% more in equities than the 10 best-funded schemes, according to a survey by actuaries Lane Clark and Peacock. However, the dynamic that interests me is the circular dynamic in play between market perceptions of regulatory change, political support for this change, and the level of underfunding of pension schemes.

The US is in the process of following a path already travelled in the UK. Proposed US accounting changes mimic FRS17, and the mark-to-market route to pension accounting will be introduced in two stages starting in 2006. Concurrently, legislative changes will introduce a new regime similar to a cross between the UK's Minimum Funding Requirement and its Pensions Act of 2004. The effect of both of these changes will be the reduction of risk on the part of pension plans, with the risk-less asset (on an asset-liability basis) being the double-A rated corporate bond.

New regulation therefore provokes greater demand for risk-less assets which have a limited supply: the risk-less asset goes up in price given higher demand and the yield falls. This translates into falling rates with which future liabilities are discounted, raising the present value of liabilities. And in a stable risk climate, these new unfunded liabilities lead to more purchases of the risk-less asset, leading to ever lower yields. The cycle can quickly lead to a self-fulfilling run on risk-less assets. Paradoxically, a move to reduce risk and increase transparency could end in higher systemic and specific risks: lower credit risk premia with higher credit risks.

Given that the liabilities of US private plans have a typical duration of around 15 years, the fixed-income portions of plans represent only around 20-30% of assets, and they are benchmarked primarily to the Lehman Aggregate index, it doesn't take a genius to make three deductions. First, there is likely to be a run on longer-dated assets leading to protracted long-dated high-quality credit yield curve inversion; second, there will be opportunities for investment banks to get involved in substantial volumes of new long-dated bond issuance; and finally a bundle of new long-dated credit mandates will be awarded over the next few years.

Whatever else 2006 has in store, it is likely to be another good one for the credit professional.

Toby Nangle is a fixed-income investment manager at Baring Asset Management.

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