How fund managers are making the pensions crisis worse

Above the urinals in Bank underground station, the all powerful Corporation of London has seen fit to affix its ancient crest of gryphons and the cross of St. George, underneath which is the Latin legend "Domine Dirige Nos", or "God direct us".

Useful advice to be sure in such circumstances, particularly given that a high proportion of the facility's users are down and outs. Whether such a portentous maxim in a dead language will improve their aim however, remains open to doubt.

Like the City Corporation, the fund management trade is particularly fond of grandiosity, for two simple reasons. First is that if a given investment concept is totally fallacious, an overlay of mumbo jumbo helps to mask this simple fact, perhaps even providing respectability. Secondly, the more complex a given idea, the higher the fees that can be charged.

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Thus the recent annual jamboree of the National Association of Pension Funds for three days was dominated by the debate over "Liability Driven Investment", which in English means "How to Avoid Paying Pensions?" For LDI is the new new thing.

Probably the majority of participants both at that conference and at similar ones elsewhere in the world are savvy enough to accept that, all things being equal, LDI guarantees to make pension fund holes larger. Yet despite this consensus, its role will nevertheless become central because the dominant human survival trait, which has made man the most successful creature on earth, will forever apply.

Pensions crisis: Why there's a black hole in pensions funding

As in nature, so in the world of institutional investment few practitioners will stray from the herd, because it substantially increases the dangers for no obvious gains. If a trustee boldly tries to increase a fund's value by operating independently of the herd, not only is there no reward and a risk that gains are actually reduced, but he will probably also be perceived as a dangerous apostate.

This was the case with Warren Buffett, during his first decade as an investment manager. If however the trustee chooses to stay not just with the herd, but in the centre, so carrying no responsibility for its direction, he benefits. His personal risk has been considerably lowered (predators pick off the macho male outliers); so not only are his chances of survival improved, but he has the pick of the females and better grazing. In human terms he prospers both in stature and material. It is from this principle that liability driven investment has been reinvented.

The ever-expanding holes in pension funds across the world are not, as commonly assumed, a function of deteriorating demographics; these have been but a secondary cause. The primary reason was that for many years chief executives had no interest whatsoever in their pension fund liabilities, as their companies were not responsible.

Moreover, finance directors could ensure rapid promotion by stealing from their employees' own funds. Hence in the majority of listed companies, the workers have one form of pension, the directors another.

This theft was very simple. By renting the most favourable actuarial forecast available, the finance director could declare a pension funding holiday for the company. Sometimes these funds were even raided to transfer money back into the company's own balance sheet. This naturally created accelerating earnings and higher dividends.

The more that the given finance director was able to accomplish this financial magic, the more successful his subsequent career. This is why large numbers of finance directors are now the CEOs of leading public companies.

Pensions crisis: Why government bonds are a bad long-term investment

Unfortunately for them, government treasuries have slowly woken up to the fact that in practice the private sector has been off-loading its pension fund liabilities onto the state. This tends to be unpopular with Finance Ministers.

As a consequence, legislation was enacted to enforce the theoretical funding of pension fund deficits by these companies, and worse, for many decades into the future. It is no coincidence that these legislative changes have taken place in Britain and elsewhere at a time when budget deficits have been widening rapidly; national treasuries need to sell a far greater volume of bonds - about £70bn worth in the case of the UK this year.

Nowhere does the pension legislation state that pension fund liabilities must be matched through the purchase of government bonds; yet the presumption is that this is the case, and it is also the optimal environment for the safety of the herd. For it means that the median trustee, finance director or institutional fund manager can avoid taking any investment decision at all, i.e. zero risk to career and income, whilst carrying out his legal and financial duties to the letter. When these policies turn sour, as they will, the new legislation can safely be blamed.

The consequences have already been well documented. Pension funds are accelerating their purchases of bonds, at yields which are unsustainably and absurdly low. In so doing, they have driven these bond yields even lower. Their actuaries then inform them they have created an even larger potential liability. Thus they have to sell even more assets, such as equities, to buy ever more bad value bonds. It is a perfect death spiral.

For all that many commentators have spotted this simple idiocy and have railed against it, the industry still follows the trend, in the unspoken certainty that liability driven investment ensures that pension fund holes will worsen over time.

A good investment has several attributes, of which the most important is that the return on capital is higher than its cost. Distilling this simple junior school concept into the real world, a good investment will have not just strong cash flow, but accelerating free cash flow.

Governments bonds by definition must fail to be a good investment over the long term, as 95% of the time governments have negative cash flow: expenditure is nearly always greater than income. Government bond markets exist solely to plug the holes created by over-expenditure.

Given that governments usually operate deficits, which can only be resolved by issuing ever more bonds at an accelerating rate, then their bonds fail the test of a really good long term investment to meet growing future pension liabilities. The essential component of an accelerating free cash flow is missing.

Some corporate and investment managers know this, and are prepared to move outside the herd. They have sensibly eschewed following the path to certain penury through investing in ever more government bonds. However, in showing admirable independence and a genuine belief that they are paid to do their best, they have fallen into an older investment trap, that of confusing size with value and safety.

Pensions crisis: Why you should use the Vodafone test

Every year, the Brazilian rain forest is reduced by an area the size of Belgium. A proportion of this timber is then made into paper, on which thousands of analysts scribble notes about the attractiveness of Vodafone.

The Reuters estimates today from 41 brokerage firms covering Vodafone show not a single sell' recommendation. The majority are buy' or outperform'. Only one brave, perhaps suicidal, company - Bear Stearns - has an 'under perform' recommendation. Charitably, the 40 others could be encouraging investors to buy because they genuinely believe what they have written (and are not after corporate finance business). However, in 2000, at £4 per share (vs. £1.28 today), of the then 52 brokers covering the company, only two had sell' recommendations.

It is therefore fair to deduce that Vodafone is a permanent buy amongst all highly paid investment advisors, whatever the share price. Clearly many investors have suffered poor returns, absolute and relative. Yet just as today refusing to buy expensive Government bonds is a career risk, so for many years not investing in Vodafone has been an unacceptable risk to most consultants and trustees.

Like bonds, on a cost of capital/free cash flow argument, the company was an intolerably high risk investment. It only managed to produce a feeble free cash flow after a decade in the year to March 2004. This is now improving and finally over the last two years has a dividend stream dribbled out of the company. Having been a shockingly bad investment for five years, Vodafone might finally be reasonable, if unexciting value.

Even so, and leaving aside important sub-components of risk analysis before investing in any company, such as whether the board is competent, unified and focussed; or is spatting and ego-strutting, like most mobile phone companies, Vodafone has many long-term business problems. One is margin erosion. The average price of calls and roaming charges' still has way to fall both because of competition and legislation. Another is saturation. With market penetration approaching 100% in most advanced countries, sales growth there must fall off a cliff. Next is technology. The mobile companies once made the old, ex-government, fixed line companies look like dinosaurs.

Now some, such as BT (with awesome free cash flow), may be about to take the lead in technology. The list of risks is long; the valuation of the company is OK, not hugely compelling (such as 2.1 times price to sales). It is very difficult to see how over the long term it can trade on a valuation any better than a mature utility or provide better than modest, single digit annual returns.

Yet it is to Vodafone and similar companies that alpha male fund managers are turning in preference to bonds. (A good test of whether a fund manager actually invests in companies or for reasons of size rather than value is a variation of Senator Joe McCarthy's question from America's 1950s communist paranoia phase. "Have you been - or were you ever - a member of the Vodafone Party?" It's a useful filter.)

Pensions crisis: Why it's about to get worse

The mis-allocation of funds to long-term government bonds or to companies largely because of their size is about to matter much more. Over the last three years, the backdrop for investment in most asset classes, from houses, to bonds, equities, and paintings, has been benign. The key reasons have been well identified. They were essentially enormous growth in money supply and collapsing interest rates, engineered particularly by the Federal Reserve Bank of America.

This favourable investment environment is corroding. While Japan and Germany were on their knees, and corporations desperately trying to repay debt, the world was awash with surplus money, and growth was driven by the peculiar and symbiotic China/America, dealer/junkie relationship. The recoveries in Japan and Germany and the return of corporate borrowing, coupled with even the dimmest central banker realising that excessive monetary growth creates long term problems, means that liquidity is becoming less plentiful.

Thus it is of interest to see fringe markets which benefited from these benign conditions curling up their toes and dying. In the last seven weeks, the Iceland stock exchange index has fallen by nearly a quarter in dollar terms; in local currency terms, those of Kuwait and Saudi Arabia by 17% and 27% respectively. Since its November 2005 high, Dubai's stock market index has halved.

We are not going to pretend that the Reykjavik or Gulf share markets are indicative of what must happen. It may be that after sharp corrections, both continue their merry upward trajectory. Major downturns in equity prices however, tend to start at the fringes. The serious collapses in 1997/8 across all emerging markets, then in Russia and South Africa, and eventually the implosion at LTCM in America, were undoubtedly triggered by the implosion of a Mickey Mouse market run by a bunch of political and corporate bandits who stole too much Thailand.

Multiple failures recently in minor markets hint that we may be near the peak of this very benign cycle. If, as we suspect, this is the case then the liability driven investment programmes, now so universally accepted in government bonds or in big cap stocks such as Vodafone, will prove doubly expensive. Domine Dirige Nos.

First published as Bedlam Asset Management's 'Pick of the Week'

For more from the unconventional fund management group, visit Bedlam