On Sept. 9, some $2 trillion in corporate defined benefit pension plan assets, affecting approximately 20 million plan participants, will be subject to new regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Yet many plan sponsors are either ill-prepared or worse yet ill-informed about Title VII of the act, which demands centralized clearing of standard over-the-counter interest-rate and credit-default swaps.
One reason companies might be caught by surprise is there are many firms that are exempt from the new rules for their own trading. But regardless of whether a company is exempt, its pension plan will be required to comply with central clearing of swaps, and preparation will be needed to retain access to these effective investment tools.
Swaps are commonly used for pension plan management. They help manage risk, reduce portfolio volatility, facilitate plan transition among investment managers and minimize transaction costs associated with rebalancing portfolios.
According to the American Benefits Council, “without swaps, plan assets and liabilities would be far more volatile, leading to greatly increased funding volatility. Increased funding volatility would, in turn, force plan sponsors to set aside much greater reserves to address possible future funding obligations.”
Given the material size of pension obligations for many plan sponsors, the use of derivatives, such as swaps, must remain an integral part of an effective investment strategy. And as of Sept. 9, there will be no choice but to implement the strategy in accordance with the new regulations.
Central clearing interposes a clearinghouse between the two parties to a trade. There are several steps that plans and their managers need to take before trading in this market under the new regulations:
- relationships with clearinghouses must be established;
- clearing members, who serve as the plan's representative at the clearinghouses, must be vetted and hired, which involves performing due diligence and negotiating legal agreements;
- compliance systems must be implemented in accordance with new obligations, such as maintaining trading records; and
- an analysis of the impact of central clearing on the plan's portfolio should be performed. This analysis will involve a review of margin requirements and the costs associated with clearing.
Clearly, compliance with the new regulations will not be simple. Critics point to the significant number of regulations that have yet to be finalized or, in some cases, even proposed. Others lament the costs of clearing associated with establishing relationships with clearinghouses, hiring clearing members, negotiating legal agreements, the increased margin requirements and new compliance procedures.
But despite the increased costs and the discomfort from what could be a steep learning curve, plan fiduciaries will appreciate how central clearing helps mitigate risk and increase transparency, in turn promoting the integrity of the U.S. financial system.
The OTC market without central clearing involves a web of one-to-one transactions; a large financial institution is typically the plan's counterparty. If one institution defaults, it might affect the ability of another institution to fulfill its obligations, thus creating the potential for systemic instability.
In a market with central clearing, the chain of contagion is broken by the clearinghouse, which is subject to strict collateral, capital and default management requirements, becoming the buyer to every seller as well as the seller to every buyer. The clearinghouse guarantees all trades in the event of a default and enforces rules to fulfill obligations using the “waterfall” of resources available.
The millions of Americans expecting retirement benefits continue to depend on plan fiduciaries to act as prudent experts in managing the assets — and liabilities — of their plans. Plan fiduciaries would be well served to work with managers and other experts to better understand and embrace the changing market, and the protections and benefits afforded by the act.
With a good understanding of the central clearing marketplace and the regulatory environment, pension professionals will be better able to effectively meet their responsibilities, which benefit not only the pension plan and its beneficiaries, but the entire financial system.
David Oaten is CEO and Robert Sichel is general counsel and chief compliance officer of Pacific Global Advisors LLC, New York.