Memorandum from the National Association
of Pension Funds
1. The National Association of Pension Funds
(NAPF) welcomes the opportunity to submit evidence to the Treasury
Committee's inquiry on the problems which have emerged in financial
markets in recent months. It is important for the health of the
economy as a whole that policymakers and market participants have
a clear understanding of the very complex causes of these difficulties.
2. In making our submission, we have focused
our comments on the impact of Northern Rock and the wider credit
crisis on pension funds as professional investors and as holders
of a wide range of traded assets.
3. The NAPF is the leading voice of workplace
pension provision in the UK. Some 10 million working people are
currently in NAPF Member schemes, while around 5 million pensioners
are receiving valuable retirement income from such schemes. NAPF
Member schemes hold assets of some £800 billion, and account
for over one sixth of investment in the UK stock market.
4. Overall, the direct impact of Northern
Rock on UK occupational pension funds has been limited. This is
because pension funds run diversified portfolios of equities,
bonds and other assets, so even those with a direct holding in
Northern Rock itself have not faced material loss. In addition,
pension funds are long term investors, the liabilities of which
often fall due many decades in the future so, over the longer
term, even the current market volatility should not harm the ability
of pension funds to pay pensions to their members.
5. Nevertheless, pension funds are heavily
exposed to the UK corporate sector as a whole (as investors and
through their sponsors) so, in so far as recent events in Northern
Rock and the wider credit market result in an economic slowdown,
there will be a short to medium term effect on the value of pension
funds' assets. While, as professional investors, we fully accept
the risks involved in market investing, attempts by some funds
to reduce market risk would be more successful if Government and
the corporate sector were to provide greater volumes of long-dated
6. To an extent, Northern Rock is the victim
of global trends, in particular the short term and abrupt credit
crunch and the widespread use of leveraged products. However,
within the UK context, it is fair to say that some questions may
need to be answered regarding the willingness of Northern Rock's
Directors to take on such risk and the effectiveness of the tripartite
regulatory system. On the latter point, we suggest that the Government
should consider the effectiveness of the system and whether any
changes are necessary. For example, it may be that the respective
roles of each of the participants should be clarified. Alternatively,
the bodies involved might need extra resources or additional skills
to keep pace with the ever-changing nature of the financial markets.
7. The reaction by the financial sector
to the sub-prime and Northern Rock crises, in particular the apparent
breakdown of trust in the inter-bank lending market, suggests
that there may be a need for greater transparency in the markets
for complex derivatives.
The Impact of Northern Rock on Pension Funds
8. Pension funds invest for the long term
in order to meet liabilities that fall due far into the future
so there is every reason to believe that the current market volatility
will not impair the ability of pension funds to pay pensions to
9. Where pension funds were invested directly
in Northern Rock's equity and bonds, they were, to some extent,
protected from the effects due to the normal practice of holding
a highly diversified portfolio of assets in a wide range of companies.
That said, it is likely that a number of funds were "overweight"
in financial companies, including Northern Rock (on yield grounds
alone) so performance will have been negatively affected.
10. We have seen no evidence that Northern
Rock's business model was seen as flawed by either the Regulator
or the market so, even with the benefit of hindsight, the decision
by some pension fund investment managers to invest in Northern
Rock seems reasonable.
Causes of the Northern Rock Crisis
11. Northern Rock's business model relied
on being able to undertake short-term borrowing on the capital
markets in order to fund its long-term mortgage business via the
use of highly leveraged term-funded off-balance sheet assets.
When the supply of credit dried up, due to the unwillingness of
the banks to buy each others' loans, the business model failed.
In many ways, the demise of Northern Rock is, therefore, less
to do with local factors than with more global trends such as
the credit crunch and the widespread use of leveraged products.
12. Questions can perhaps be raised about
the way in which this risk was managed both internally by the
company's Directors and externally by the Regulators.
13. With regard to the effectiveness of
the tripartite oversight model, it is unclear to pension funds
as "outsiders" whether the system is ineffective. To
address this issue, we believe that the Government should consider
the current arrangements and see whether they might, in any way,
be improved. For example, it may be that roles need to be clarified
or additional resources or skills may be needed to effectively
supervise a sector in which practices are constantly changing
14. NAPF members are substantial depositors
with the UK banking system but have always been, and should remain,
outside the scope of any depositor protection scheme. It is the
role of their managers and advisers to ensure that deposits are
sufficiently diversified so as to reduce any damage to value from
insolvency or illiquidity.
15. Derivatives have been widely used for
several years. However, what is new is the extent to which banks
have in recent years packaged up differing forms of debt in securitised
form and sold it on. This practice removes credit risk from bank
balance sheets, but has lead to uncertainty as to where such risks
lie. In recent months, such uncertainty has caused a liquidity
crisis as banks have been unwilling to deal with each other (for
fear that some have done a worse job than others of shedding credit
16. What is certain, however, is that if
the balance sheet problem is rooted in confidence in the wholesale
banking market, greater transparency would have been desirable,
particularly around the use of certain investment vehicles. Such
transparency should answer the questions of who funds them and
who carries the risk.
17. While substantial data is available
on some structured credit products, the complexity of the data
analysis has led to a high reliance on ratings and the agencies
that supply them. AAA or top short-term ratings were deemed sufficient
assurance for many, but clearly the mark-to-market risk has proven
much greater than anticipated (eg the vulnerability to market
dislocation and illiquidity). It is likely that the absence of
data from previous credit crises in recent years may have resulted
in mis-estimation by agencies of correlations and underlying credit
risk. However, many professional investors, especially the banks,
do not usually rely on the rating agencies for their estimates
of the risks posed. Instead, it is common practice for them to
make their own assessments of the risks and rewards of such products.
18. The fact that issuers pay for ratings
and benefit from high ratings can lead to agency and rating methodology
arbitrage by issuers. This is an area for concernrating
agencies and methods with impaired credibility results in seizure
in market segments previously reliant on them.
19. In recent years, many UK pension schemes
have been reducing their exposure to risk (de-risking) by switching
assets from equities, which are relatively volatile, to bonds
composed principally of UK Government and investment grade corporate
bonds, which better match pension funds' liabilities. Unfortunately,
this necessary switching has been impeded by the very limited
availability of long-term Government and corporate bonds. In consequence,
a small minority of pension funds, in order to gain good returns
at lower volatility may have invested in complex derivatives such
as Collateralised Debt Obligations (CDOs) and hedge funds.
20. However, the exposure to (and potential
losses from) CDO type strategies employed by hedge fund managers
will be very small relative to the total pool of pension fund
assets. Even where pension funds have opted for more active bond
mandates which do involve some exposure to CDOs, and which may
include sub prime mortgage debt, industry experts estimate that
this exposure amounts to no more than 1-2% of assets. In light
of this, the direct impact of exposure to CDOs would be very small.
This is confirmed by the NAPF's own 2006 Annual Survey which shows
that UK pension schemes have only a small exposure to hedge funds
(circa 1% of total assets in defined benefit schemes). Separately,
it has been estimated that the majority of hedge fund assets are
held via relatively diversified fund of funds vehicles rather
than in isolated individual hedge funds. (Pension Fund Indicators
21. The Northern Rock issue is a symptom,
rather than a cause of the challenges currently facing the financial
sector. At heart, these relate to wider global trends in the availability
of credit and the use of leveraged products as well as to the
apparent breakdown in trust between the banks.
22. As long term investors, the current
troubles should not materially harm the ability of pension funds
to pay pensions to their members, although they will affect asset
values in the short to medium term. Nevertheless, the task of
paying pensions would be made easier if the Government and the
corporate sector were to issue more long-dated bonds.
23. We believe that there is little that
the Government or Regulators can do in the short term to address
the immediate effect of the credit crisis as the banks and others
affected will have to work through the consequences of their recent
activities. Patience and market-led solutions will deliver but
at considerable cost to some organisations, their management and
their shareholders. However, it may make sense for the Government
to review the current "tripartite" regulatory regime
and to consider whether greater transparency can be achieve in
the market for structured investment vehicles.