Archive for June 2019

Brendan McLean

Illiquidity alert

The expanse of liquidity scandals coming out of the asset management industry should be a warning to investors. In less than a year, there have been at least three well-published events: GAM, Woodford and H20. Even the governor of the Bank of England, Mark Carney, has warned that daily dealt funds that are not liquid are “built on a lie” and if nothing is done they could pose a systemic problem.

With the increasingly difficult search for yield, fund managers are diving deeper into more illiquid assets. When investors in their daily dealt funds want their money back after a change in sentiment, some negative news or performance of a fund, a ‘fire sale’ can be triggered where investors want their money back immediately. In reality, this may not always be possible for some daily dealt and other funds with longer redemption periods. When a client wishes to redeem, the manager normally disinvests from holdings which are the most liquid and the cheapest to sell. When more and more investors redeem, the fund becomes more illiquid. Then investors panic as they do not want to be left with the illiquid assets resulting in many redemptions happening at once. This overloads the manager, who is unable to sell the underlying investments to meet the redemption requests and often they must suspend the fund to manage the sale of these assets.

Investors should understand their fund managers’ investment philosophies and have confidence in their portfolio management skills, in addition to seeing that they have a robust risk management team. Clients should be cautious of star managers who have too much influence over the risk management process. They should avoid making up a large portion of a fund as they may struggle to redeem even under normal circumstances. Investors should not be chasing yield without considering the risks carefully; whilst it’s frustrating that returns are low, having money tied up in an illiquid suspended fund would be even more so.

GAM

In July 2018, the Swiss asset manager GAM suspended leading bond manager Tim Haywood after a whistle-blower raised concerns about his conduct, namely breaching due diligence rules and company policies. This triggered a huge wave of redemptions and ultimately the closure of £8.5bn of fixed income funds. Subsequently, the GAM chief executive stepped down and the share price declined 70%. The main issue faced by investors was getting their money back as the funds had a lot of illiquid holdings which were hard to sell.

Woodford

On 3 June 2019, the popular Woodford Equity Income Fund, managed by fallen star manager Neil Woodford, began to make mainstream headlines as dealing in the fund had been suspended. This was due to serious liquidity issues after continued mass outflows from consistently poor performance. According to MSCI, at the end of 2018, 85% of the fund’s net asset value invested was in illiquid securities, which creates a major issue around selling assets and returning clients’ capital.

The FCA is now investigating Woodford for breaching liquidity rules.

H20

The most recent case study took place on 18 June. H2O Asset Management, a subsidiary of French group Natixis Investment Managers, was the subject of a Financial Times article detailing that the fund had bought some illiquid bonds linked to entrepreneur Lars Windhorst, who has a history of bankruptcy, various legal troubles and a suspended jail sentence. The CEO of H20 was appointed to the advisory board of a Windhorst company raising the appearance of a possible conflict of interest; he has since resigned, but needless to say this has triggered a wave of redemptions.

With $13 trillion of global fixed-income assets currently generating a negative yield, the temptation for fund managers to take more risk and move into more illiquid assets to generate higher yields is hard to resist. This means it is highly possible that more illiquidity scandals will happen. Mark Carney has called for increased regulations to ensure investors are not misled, and European regulators are designing new liquidity rules for funds, which will hopefully offer better protection for investors.

Angela Burns

The Financial Conduct Authority (FCA) recently produced the results of its DB transfer survey in which it stated it was ‘concerned and disappointed’ at the amount of DB transfers. A statement which, I imagine, is based on the assumption that transfers are not always in the member’s best interests, and a belief that a high number of transfers means that incorrect decisions are being made.

Transfer values can be extremely beneficial for individuals given the right circumstances. Recent low yields will also have made transfer values attractive.

It has been a requirement for some time that individuals have to obtain independent financial advice before transferring amounts over £30,000. This should have helped manage the risk of dubious decision making. However, the concern now is that financial advice is not meeting the mark and poor decisions are being made right, left and centre.

The FCA is working to combat advisers that are not providing advice of the expected standard. They are writing to firms where a potential for harm has been identified, to set out expectations for transfer advice and actions the firm should take to improve the quality of their advice.

This is a great project to tighten up standards across the industry. I expect, however, that it could be a slow process.

Trustees can also take measures now to protect members’ interests by giving them a route to quality financial advice rather than having them rely on the powers of Google. ‘At Retirement’ platforms can be used to ensure individuals are:

  • aware of their options under the scheme
  • understand these options, and
  • have a straight through process to a trusted adviser to provide them with quality, well-considered advice.

This should also help to protect pension scheme members against pension scams which are becoming more complex and imaginative in every iteration.

The issue has to be tackled both from an industry perspective and a scheme perspective to ensure good outcomes for all. An excess of poor financial advice may result in a repeat of the mis selling scandal. It is important that trustees and IFAs make sure they are not in the firing line.

Alan Collins

The ultimate goal of a defined benefit scheme is clear – to ensure that all members receive the benefits they have built up in the scheme. For most schemes, this will involve some form of insured solution at a point in the future where remaining benefits are secured and the scheme is then wound-up. For some that will come sooner; for others it is currently a very distant prospect.

The UK funding regime has historically “ignored” this ultimate end point – rather, we have the somewhat vague construct of technical provisions (ongoing funding basis). This is the liability target required in funding valuations which must be prudent, but need not remove all future risks. Typically, you might see this liability target sitting in the region of 60-80% of the cost of insuring scheme benefits. Therefore, even if a scheme is 100% funded on the technical provisions basis, it will not be able to insure the benefits without significant further investment returns or significant further contributions from the sponsor.

As most of us working in defined benefit pension schemes already know, a scheme’s technical provisions are only a stepping stone towards the ultimate goal. What happens once full funding on an ongoing basis is achieved?

Over recent years, to assist scheme trustees with forward planning, the Pensions Regulator has introduced the concept of the long-term funding target (LTFT). The LTFT is defined as “the level of funding the scheme will need to achieve in order to reduce its dependence on the employer”. To me, this translates as meaning the buyout level funding or a level of funding that can be managed towards buyout without material further contributions from the sponsor.

The LTFT is now a key part of valuation discussions for 2019 and beyond. This is particularly the case for rapidly maturing schemes where the journey time to end point is getting shorter and shorter. The LTFT need not (and in most cases will not) bring about a change to the ongoing funding target or any immediate changes to the investment strategy. What it should do is bring about discussions on journey planning (both in the short and long-term), managing and reducing risk over time and possibly setting triggers that will reduce risk as the funding level improves and/or as the scheme matures.

Yields are returning to very low levels resulting in higher and higher liability values. As such, the funding challenges for pension scheme trustees show no sign of getting any easier. However, I am confident that looking to the future and setting clearly defined long-term targets (and clearly planning for how they will be achieved) will serve trustees well over the years ahead.

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