There has been much media coverage dedicated to the impact of the current
economic crisis on investment values and how defined benefit pension schemes are
becoming an increasing burden on companies that are already struggling. While
trustees are being encouraged to be more flexible and supportive, to ensure that
their sponsors survive the crisis, what can be taken from recent events?
Many commentators have expressed the view that the crisis was a ‘black swan’
a highly improbable event that is difficult to forecast. In our view the
bursting of the bubble was nothing of the sort and was, in fact, in the words of
Watkins and Bazerman ‘a predictable surprise’.
A predictable surprise has the following features:
At least some people are aware of the problem; It gets worse over time;
and It’s likely to explode into a crisis eventually but is not prioritised by
key decision-makers or they do not respond fast enough to prevent severe
One might think that an understanding of history and human psychology should
better equip investors to understand the warning signs, the opportunities and
the pitfalls associated with the formation of bubbles.
According to the Kindleberger/Minsky framework, bubbles have predictable
Displacement: an event that creates profit opportunities, such as the
expansion in world trade brought about by the rapid development of the Indian
and Chinese economies; Credit creation: monetary expansion brought about through
the development of new credit instruments and the increasing use of leverage;
Euphoria: prudent risk management is forgotten as asset values are seen as
capable only of going up; Financial distress: excess leverage begins to be seen
as a problem, insiders cash out and frauds emerge; Revulsion: investors are so
traumatised by events that they are not prepared to participate in the market,
which combined with distressed asset sales leads to cheap asset prices.
Why then is it not possible, early in the cycle, as the tremors of
uncertainty that serve as the warning precursors are felt, to avert disaster?
Perhaps part of the answer lies in Freud’s repetition compulsion activity,
whereby people feel something along the lines of, ‘let’s do what we always do
because, although the results will be awfully painful, at least we know that,
which is better than doing something different and not knowing what the results
A more mundane explanation may be that crashes only occur when there is
consensus that markets have reached a point where risk and reward are out of
balance. Therefore inevitably the majority of investors will not see it coming,
because the very realisation is what causes the bubble to burst.
But if human behaviour dictates that, left to their own devices, markets must
go through cycles, what can be done? Perhaps regulatory intervention is
required, if not to eliminate peaks and troughs of economic activity, at least
to moderate them by limiting market excesses and the formation of bubbles.
Given the predictability of bubbles, what can pension scheme trustees and
sponsors take from this analysis?
To state the obvious, investment values can fluctuate significantly. What has
apparently not been so obvious is that, when a bubble bursts and investment
values crash, employers are also usually suffering in adverse trading conditions
and are unable to fund the resulting gap. Investment risk and employer risk are,
therefore, highly correlated.
Accordingly, the best time to fund a scheme is when the employer can afford
to pay and the best time to de-risk is when equities are performing well. This
won’t be the last recession so, when the market recovers, accelerate scheme
funding and de-risk.
People may agree with this sentiment now, in the current climate, and forget
about it when the euphoria returns, unless the knowledge is institutionalised in
the operations of the sponsor and the scheme
The alternative is to rely on regulation, which has not proven effective to
date. If bubbles are a by-product of human nature, we may be damned to the kind
of financial fibrillation in which economies currently find themselves. However,
while the details of bubbles change, the general patterns remain similar.
Therefore they are predictable and sponsors and trustees of pension schemes,
which are very long term vehicles, should plan accordingly.
Gary Squires is a partner and head of pensions advisory
services at Zolfo Cooper.
Mike Caplin is a psychometrician and an executive mentor.
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