Select Committee on Treasury Written Evidence

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 bonds.

  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 their members.

  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 and evolving.


  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 risk).

  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 concern—rating 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 2006, UBS)


  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.

November 2007

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