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Pension buyouts carry needless credit risks

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Imagine you are a banker and a customer approaches you for a loan of £850,000 to buy a £1m house. Would you be willing to lend the money on an unsecured basis, or would you first insist on taking a charge over the property? 

It seems a silly question. Of course you’d do the latter. But let’s park that for a moment and imagine our customer has even more extravagant demands. Not only do they refuse to put up any collateral, they want the loan to be “non-accelerable”. So even if they miss an interest payment, the lender can’t demand immediate repayment of the loan in full.

Sounds like an interesting proposition? I think most lending institutions would tell that customer to take a hike.

Now let’s look at what happens when defined benefit pension schemes insure their liabilities to pay future retirement incomes. It’s increasingly common. In the last 12 years, schemes with liabilities worth £175bn have sought insurance protection through so-called buyouts, according to consultants Lane Clark Peacock. That’s almost a tenth of the £2tn-plus of scheme liabilities outstanding in the UK. 

Under the traditional pension arrangement, an average scheme funds roughly 90 per cent of its liabilities with assets and relies on its sponsoring company to make good the shortfall.

With buyout deals, that same scheme transfers all of those assets plus a premium to an insurance company. In the process it surrenders title to the assets and control over how they might subsequently be invested. What it receives in return is a piece of paper promising to pay the insured pension payments as they fall due.

One way to think about this is that the scheme has lent money to the insurer which it has used to buy the scheme’s assets. In the process, the trustees have contrived to forfeit any security and the right to foreclosure. Even if the insurer defaults on a payment, they cannot recover their investment.

It is easy to see the appeal to the insurer. Just as our demanding bank borrower wanted, it gets no-strings, long-term money. Even better, it only has to pay a few basis points over government bond rates.

No wonder so many clever financiers have homed in on pension buyouts — insurers such as PIC and Rothesay. After all, they get to reinvest some of the assets they inherit from insured schemes in higher yielding instruments, keeping much of the surplus earned over the rock-bottom funding cost. 

Meanwhile, many of these insurers put up very little tangible capital. As they switch some of the transferred funds out of boring gilts into higher-return instruments, the regulator permits them to discount scheme liabilities at that higher rate. This essentially manufactures equity (a practice known as “Matching Adjustment”) by recognising up front future profits deemed to be risk free. 

For many of the specialist players this is pretty much all their equity. Take the three most focused operators, PIC, Rothesay and Just Group. Collectively they had £13.7bn of regulatory net assets, according to their 2019 Solvency and Financial Condition Reports. But, strip out the Matching Adjustment, and that fell to just £172m.

Anyway, goes the salesman’s patter, insurers are as safe as houses. The regulator applies tough rules that prevent insurers from acting recklessly. And should one get through the net, the Financial Services Compensation Scheme offers 100 per cent protection for retirement incomes.

Yet how much credence these assurances deserve is debatable. While the UK’s insurance regime is sound on paper, recent financial history suggests that regulators are never infallible. Meanwhile the FSCS is essentially an unfunded scheme. In the event of large losses, much would depend on a future government being willing to use taxpayers’ funds to bail out some of the UK’s wealthier citizens.

It is hard to avoid the conclusion that pension schemes are being unusually trusting with their members’ hard-earned savings. Neither a bank nor a fund manager would lend on anything like these lax terms. Nor is there any compelling reason why pension trustees should do so to insure future liabilities. Scheme members might usefully ask them why they are so compliantly playing along.

jonathan.ford@ft.com



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Earnings beats: lukewarm reaction shows prices are stretched

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Investors are picking over first-quarter results for signs of economic recovery and proof that record market highs can continue. Stock markets have only been this richly valued twice before — in 1929 and 2000. Bulls hope strong corporate earnings and rising inflation can pull prices higher still. But pricing for perfection means even good results can be met with indifference.

L’Oreal illustrated this trend on Friday. The French cosmetics group stated that sales in the first quarter of the year rose 10.2 per cent. This was a better performance than expected. Yet the announcement sent shares down by around 2 per cent. Weak cosmetics sales were seen as a veiled warning that consumers emerging from lockdowns might not spend as freely as hoped.

Online white goods retailer AO World, a big winner from pandemic home upgrades, also offered a positive update this week. In the quarter that marked the end of its financial year, sales were £30m ahead of forecasts. But even upbeat commentary from boss John Roberts could not stop shares slipping 3 per cent.

Banks are not immune. Their stocks have outperformed the market by 7 per cent in Europe and 12 per cent in the US this year. But stellar Wall Street results were not enough to satisfy investors this week.

JPMorgan Chase, the biggest US bank, smashed expectations for the first quarter. Even adjusting for the release of large loan loss reserves, earnings per share beat expectations by 12 per cent because of higher investment banking revenues. Bank of America earnings also rose thanks to the release of loan loss reserves. Yet shares in both banks ended the week down. Goldman Sachs had to pull out its best quarterly performance since 2006 to hold investor interest.

On multiple metrics, stock valuations look steep. On price to book, banks are now back to the pre-crisis levels recorded at the start of 2020. Living up to the expectation implicit in such valuations is becoming increasingly hard.

Lex recommends the FT’s Due Diligence newsletter, a curated briefing on the world of mergers and acquisitions. Click here to sign up.



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Barclays criticised for underwriting US private prison deal

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Barclays has attracted criticism for underwriting a bond offering by the US company CoreCivic to fund the building of two new private prisons, in a new dispute over Wall Street’s relationship with the controversial sector.

The UK-based bank said two years ago that it would stop financing private prison companies, but the commitment did not extend to helping them obtain financing from public and private markets.

About 30 activists and investors, among them managers at AllianceBernstein and Pax World Funds, have signed a letter opposing the $840m fundraising for two new prisons in Alabama, which was due to be priced on Thursday.

The signatories said the bond sale brings financial and reputational risk to those involved and urged “banks and investors to refuse to purchase securities . . . whose purpose is to perpetuate mass incarceration”.

Activists and investors who pay attention to environmental, social and governance issues have sought to cut off companies that profit from a US criminal justice system that disproportionately incarcerates people of colour. As well as raising ethical issues, many also say such financing may be a bad investment because legislators are increasingly calling for an end to the use of private players in the prison system.

While Barclays is not lending to CoreCivic, activists and investors attacked its decision to underwrite the deal, which is split between private placements and public issuance of taxable municipal bonds. The arrangement is “in direct conflict with statements made two years ago” when the bank announced it would no longer finance private prison operators, according to the letter.

Barclays said its commitment to not finance private prisons “remains in place”, adding it had worked alongside representatives from the state of Alabama to finance prisons “that will be leased and operated by the Alabama Department of Corrections for the entire term of the financing”.

CoreCivic said the Alabama facilities will be “managed and operated by the state — not CoreCivic. These are not private prisons. Frankly, we believe it is reckless and irresponsible that activists who claim to represent the interests of incarcerated people are in effect advocating for outdated facilities, less rehabilitation space, and potentially dangerous conditions for correctional staff and inmates alike.”

Barclays’ 2019 commitment to limit its work with private prison companies came as other banks, including Wells Fargo, JPMorgan Chase and Bank of America, also said they would stop financing the sector.

Critics said they were not sure why Barclays is differentiating between lending and underwriting.

“You’ve already taken the stance, the right stance, that private prisons and profiting from a legacy of slavery is bad,” said Renee Morgan, a social justice strategist with asset manager Adasina Social Capital, one of the signatories of the letter. “But then you’re finding this odd loophole in which to give a platform to a company to continue to do business.”



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Hedge funds post best start to year since before financial crisis

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Hedge funds have navigated the GameStop short squeeze and the collapse of family office Archegos Capital to post their best first quarter of performance since before the global financial crisis.

Funds generated returns of just under 1 per cent last month to take gains in the first three months of the year to 4.8 per cent, the best first quarter since 2006, according to data group Eurekahedge. Recent data from HFR, meanwhile, show funds made 6.1 per cent in the first three months of the year, the strongest first-quarter gain since 2000.

Hedge fund managers, who often bet on rising and falling prices of individual securities rather than following broader indices, have profited this year from a rebound in the cheap, beaten-down so-called “value” stocks and areas of the credit market that many of them favour. Some have also been able to profit from bouts of volatility, such as the surge in GameStop shares, which turbocharged some of their holdings and provided opportunities to bet against overpriced stocks.

“We’re going into a market environment that is going to be more fertile for most active trading strategies, whereas for most of the past decade buying and holding the index was the best thing to do,” said Aaron Smith, founder of hedge fund Pecora Capital, whose Liquid Equity Alpha strategy has gained around 10.8 per cent this year.

The gains are a marked contrast to the first three months of 2020, when funds slumped by around 11.6 per cent as the onset of the pandemic sent equity and other risky markets tumbling. However, funds later recovered strongly to post their best year of returns since 2009.

This year, managers have been helped by a tailwind in stocks and, despite high-profile losses at Melvin Capital and family office Archegos Capital, have largely survived short bursts of market volatility.

It’s a “good market for active management”, said Pictet Wealth Management chief investment officer César Perez Ruiz, pointing to a fall in correlations between stocks. When stocks move in tandem, it makes it more difficult for money managers to pick winners and losers.

Among some of the biggest winners is technology specialist Lee Ainslie’s Maverick Capital, which late last year switched into value stocks. Maverick has also profited from a longstanding holding in SoftBank-backed ecommerce firm Coupang, which floated last month, and a timely position in GameStop. It has gained around 36 per cent. New York-based Senvest, which began buying GameStop shares in September, has gained 67 per cent.

Also profiting is Crispin Odey’s Odey European fund, which rose nearly 60 per cent, having lost around 30 per cent last year, according to numbers sent to investors.

Odey’s James Hanbury has gained 7.3 per cent in his LF Brook Absolute Return fund, helped by positions in stocks such as pub group JD Wetherspoon and Wagamama owner The Restaurant Group. Such stocks have been helped by the UK’s progress on the rollout of the coronavirus vaccine, which has raised hopes of an economic rebound.

“We continue to believe that growth and inflation will come through higher than expectations,” wrote Hanbury, whose fund is betting on value and cyclical stocks, in a letter to investors seen by the Financial Times.

Additional reporting by Katie Martin

laurence.fletcher@ft.com



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