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A version of this article first appeared in Total Derivatives.
Total Derivatives is the prime source of real-time news and analysis of the global fixed income derivatives markets.
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In late January, the European Court of Justice issued its clarification of member states’ responsibilities for failed or underfunded pension funds (go to totalderivatives.com for full details of the judgment). It seems certain that the conclusion was not the extreme one that the UK government dreaded but ultimately didn’t expect.
Reactions range from panic to relief. At the panic-stricken end of the reaction scale is Colin Mouque, a director at Alexander Forbes Financial Services, who told IPE.com that "this could be a terrible blow for the Pension Protection Fund (PPF). If the High Court orders full compensation, the PPF will be bust within two years."
Cruel fate
Given that the UK’s PPF only became operational on April 6 2005, that would seem too cruel a fate. A grave, but somewhat more hopeful, tone was struck by Tim Keogh, of consultancy group Mercer. He says: "The European Court’s ruling indicates that a compensation system does not have to provide 100% cover for pension losses following employer insolvency, but protecting less than 50% of benefits is not good enough. This raises the question of whether PPF protection – which in practice only provides non-pensioners with about 60% to 70% benefit cover, rather than the 90% headlined – would be considered adequate." Keogh warns that the government’s concern now will be to avoid being forced by the UK High Court into paying higher compensation for past pension losses. Mercer estimates the cost "to be around £900 million on top of the £783 million already committed to the [now superseded] Financial Assistance Scheme".
And it could get worse for the UK government. Mercer’s Keogh adds: "As it stands, the UK’s pension system is only sustainable if scheme members continue to accept a degree of risk. If the UK High Court finds the PPF still leaves too much risk in the system, the bill for avoiding future claims could run into billions, further accelerating scheme closures."
Inflation market might prosper
One further complication was hurled into the mix by analysts at Barclays Capital, who notes: "As far as we can see, the ruling says nothing about indexation. Recall that PPF liabilities are indexed at 0% to 2.5% (effectively capped). If this is the case that the ruling requires a move to full indexation (ie, pre-2005 benefits indexed at 0% to 5%), then this would significantly increase the likely demand for inflation from the PPF as it would have to provide retrospective indexation on any benefits that it takes on."
That could be good news for the inflation market but BarCap clearly isn’t predicting dramatic market repercussions from the ECJ judgment. "In all likelihood, this means that the PPF levy is likely to have to rise (the current estimate for the financial year 2007/08 is £675 million) as this was based on total s179 liabilities of £670 billion as opposed to the full buyout estimate of £1,075 billion. At the margin, this may provide a further incentive for underfunded corporate schemes to begin to address corporate defined benefit deficits and so should be supportive of continuing flows related to liability-driven investment. However, we would maintain our view that such flows are as much a factor of market levels and corporate transactions as regulation alone."
The ruling will change the plans of those players that were specifically geared up to enter into LDI trades in the event of an unfavourable outcome. Thus, the only actual impact it will probably have on the curve will be seen in the extent to which traders will have their faith in LDI’s potency as an engine of curve-flattening tested. And that is probably impossible to gauge.
One further complication was hurled into the mix by analysts at Barclays Capital, who notes: "As far as we can see, the ruling says nothing about indexation. Recall that PPF liabilities are indexed at 0% to 2.5% (effectively capped). If this is the case that the ruling requires a move to full indexation (ie, pre-2005 benefits indexed at 0% to 5%), then this would significantly increase the likely demand for inflation from the PPF as it would have to provide retrospective indexation on any benefits that it takes on."
That could be good news for the inflation market but BarCap clearly isn’t predicting dramatic market repercussions from the ECJ judgment. "In all likelihood, this means that the PPF levy is likely to have to rise (the current estimate for the financial year 2007/08 is £675 million) as this was based on total s179 liabilities of £670 billion as opposed to the full buyout estimate of £1,075 billion. At the margin, this may provide a further incentive for underfunded corporate schemes to begin to address corporate defined benefit deficits and so should be supportive of continuing flows related to liability-driven investment. However, we would maintain our view that such flows are as much a factor of market levels and corporate transactions as regulation alone."
The ruling will change the plans of those players that were specifically geared up to enter into LDI trades in the event of an unfavourable outcome. Thus, the only actual impact it will probably have on the curve will be seen in the extent to which traders will have their faith in LDI’s potency as an engine of curve-flattening tested. And that is probably impossible to gauge.