LONDON - Zeneca Group P.L.C.'s innovative protection strategy might be a trendsetter for companies keen to maintain high equity exposure in their pension funds while avoiding the risk of making unexpected cash contributions.
At a time when loss of the tax credit on advanced corporation tax has threatened funding levels in British pension funds, the strategy may provide a much-needed boost to U.K. defined benefit schemes as financial executives ponder whether to abandon them.
Protection strategies also have growing appeal to pension fund officials who want to lock in gains from high-flying equity markets.
Zeneca's gambit is designed to be a self-financing way of protecting against downside risk while maintaining the (British pounds) 1.7 billion ($2.86 billion) pension fund's high equity allocation, currently exceeding 70%.
Through combination of an asymmetrical tactical asset allocation overlay run by First Quadrant Ltd., London, and out-of-the-money put options purchased by Zeneca's treasury department, the strategy is geared to protect both the fund and the company from a bear market.
Those risks are very real. "Equities are stretched and we are likely in for a long period of underperformance," said Bill Goodsall, managing director of First Quadrant. The likelihood of double-digit equity returns continuing into the future "seem below zero."
A major bear market could be a big factor in driving global economies into recession, and could cause U.K. companies to fall afoul of the 1995 Pensions Act's minimum funding requirements. The combined threat creates "a black cloud" over pension funds, Mr. Goodsall added.
The MFR requirement, which is being phased in over the next 10 years, would require companies to make cash injections within a year should funding levels fall below 90%. Companies will have up to five years to build funding levels up to 100%.
Consultants said pension officials at a number of major U.K. funds are starting to examine similar protection strategies.
In Zeneca's case, the downside protection is needed because the fund is only 105% funded, compared with a roughly 125% industry average.
Officials at the London-based pharmaceuticals firm were concerned about the risk of "being short cash to invest in R&D," said Ray Martin, head of group retirement benefits.
Removal of the ACT tax credit theoretically reduces the Zeneca scheme's funding level to 95%, although government and actuarial officials now have said U.K. pension plans should continue using the same calculations until a thorough review of U.K. actuarial practices is carried out (see U.K. rules story below).
The new strategy helps Zeneca overcome a mismatch between its long-term policy benchmark and its MFR benchmark.
The fund's policy benchmark is 52.5% U.K. equities, 20% overseas equities and 27.5% U.K. bonds. In contrast, the more short-term-oriented MFR benchmark is 52.5% U.K. equities and 47.5% U.K. bonds. (As now structured, the MFR test provides assumed returns for U.K. stocks and bonds only.)
That creates a mismatch between the two benchmarks equal to 20% of assets. If a bear market occurs, the Zeneca pension fund could become underfunded, with the risk of an unexpected cash contribution being required of the company.
To cover that mismatch, Zeneca trustees hired First Quadrant to provide downside protection through a TAA overlay. Unlike First Quadrant's standard TAA product, which changes a fund's effective asset mix up or down, this product will use derivatives only to reduce the Zeneca's equity exposure.
The manager is permitted to shift the fund's equity exposure into U.K. gilts, international bonds and cash, up to 20% of plan assets if its model shows equity markets are overvalued.
Mr. Goodsall said the prospect for equities relative to bonds "ranges from unattractive to horrible" in a five- or 10-year view.
In a period of low inflation and low interest rates, prospects for growth in mature markets such as Great Britain and the United States are pretty dim, he added.
The result could be "a non-standard bear market" in which plunging equity prices are accompanied by falling bond yields.
Mr. Goodsall said he is more than 80% confident First Quadrant's model would take action ahead of a major downturn, but there remain the risks that either the model would fail or a major unexpected event - such as an earthquake in Tokyo - could cause a downdraft in financial markets.
To protect against such catastrophic risk, Zeneca's treasury department has purchased out-of-the money put options to cover the 20% mismatch. Three options purchased from different counterparties, with maturities ranging between 2006 and 2008 and yields ranging between 7% and 9%, give Zeneca insurance against a 10% decline in markets.
The options protect against a decline in the fund's MFR value by more than two percentage points, and will be good until the fund's next valuation in two-and-a-half years, Mr. Martin explained.
Abolition of the ACT tax credit, however, has put a dent in the strategy. "Unfortunately, we didn't count on the chancellor taking 10% (of the fund's value)," Mr. Martin said.
Mr. Martin said the options strategy costs Zeneca about 20 basis points a year. But the fund hopes to gain about 50 basis points annually in added value from First Quadrant's overlay strategy, providing a net gain. Any gains, of course, ultimately will lower the company's pension contribution.
One analyst at a major securities firm, who asked not to be named, said the options strategy is "reminiscent of portfolio insurance" but without the dynamic option pay-out. Instead, Zeneca's strategy tries to use the liquidity of the futures market, he said.
"It's portfolio insurance with more flexibility than what portfolio insurance allowed, and linked up (First Quadrant's) type of TAA," he added.