Should Your Pension Plan Cater for Crypto?
If 2018 was a year that the cryptocurrency hedge fund industry would soon rather forget, then selective amnesia loves company as pension funds licked their wounds from a Tom Brady-esque fourth quarter.
A stock market tumble in the dying minutes of the last quarter of 2018 could wipe out earnings at companies with determined pension plans such as AT&T, Verizon and Ford because of how they account for fluctuations in their pension plans.
Many companies account for gains and losses in their pensions and retiree-benefit plans in the same year that they occur, instead of spreading them out over a number of years. So losses clocked in one year, go towards the value of that year’s pension plan.
This accounting methodology is known as “mark-to-market” and provides the most accurate real time picture of the state of a pension plan’s assets.
For most companies, pension plans were on track for a boost last year until markets took a nose dive towards the last quarter on the back of slowing growth in China, a potential trade war between the United States and China as well as the prospect of a hawkish Fed raising interest rates.
The result has been that pension plans are likely to report losses that will put a drag on company bottom lines (as shortfalls will need to be compensated for from other sources for defined pension plans).
And with increasing market volatility, many companies with defined-benefit plans could see their earnings in 2019 and beyond hit by a stock market that thus far has provided consistent gains and uninterrupted growth.
On Wednesday, Ford announced fourth quarter earnings which included a staggering US$877 million pre-tax loss from a pension adjustment, citing “adverse financial market conditions that occurred late in the last year.”
The result of pension plan losses are more immediate in companies that adopt a mark-to-market approach for valuing their pension plans, something which the hedge fund industry is far more accustomed to.
Because hedge funds generally provide greater liquidity, Net Asset Value (NAV), in some funds is calculated on a daily basis. At pension funds, because the mandate is long-term growth, profits and losses affecting NAV tend to be smoothed out over a number of years, except at companies like Ford, which take a mark-to-market approach.
Although the accounting methodology of mark-to-market reflects greater immediacy of the current state of a pension plan’s financial conditions, it also increases its annual volatility.
Up till the third quarter of last year, the S&P500 was up 9%, which meant that most pension plans were well in the black. But because of a late quarter stock market dump, the S&P500 shed 15% leaving the S&P500 at an overall loss of 6% for the year and sending many defined-benefit pension plans under water.
That presents itself as a double whammy for companies whose defined-benefit pension plans are also tied to overall earnings. When the value of pension plan assets go down, they act like a parachute because those losses need to be made up for from other areas of earnings (pensions can be seen as long term financial obligations of the company to its employees, or a liability on the balance sheet).
Even at companies with defined-benefit pension plans that don’t adopt mark-to-market accounting, losses in the stock market will simply mean that the money needs to be made up for over a longer period of time — but that doesn’t mean that the problem has necessarily gone away — it just means that pension fund managers will need to look for alpha in other places.
And those other places may also seem to be the most unlikely.
In All The Right Places, I’m Feeling So Good
It may come as a surprise but pension funds actively invest in a variety of areas, including in some more risky sectors of the investing world such as venture capital and private equity and it appears, even cryptocurrencies are no longer off the table.
With stocks no longer providing the assured growth and with company valuations at eye-watering levels, astute managers are expanding their investment horizons to what has hitherto been considered a taboo asset class.
But the argument for even a small allocation by pension funds in specific cryptocurrencies may be a sound one.
With cryptocurrency prices now currently trading at lows and with many pension funds tending towards a longer time horizon, now if any, seems like a good time for considering some cryptocurrency.
Take Bitcoin for instance. Pension funds generally stayed away in the early days of the Bitcoin boom and understandably so. Most managers were just getting up to speed about custody solutions and fund administrators were just learning the subtleties of determining NAVs for this new class of assets — still learning I might add.
And gearing up cryptocurrencies for the institutional space is no cakewalk. Take for instance Bitcoin — contrary to popular belief, there is no one universally agreed price for the digital asset. And while many media outlets are content to glean that price discovery from CoinMarketCap (a cryptocurrency pricing website), the price reflected on the site is based on an algorithm (opaque to everyone except its creator) drawing from several sources and weighted to give a “blended price” — think of it as a mystery ingredient Frappucino or a hot dog from Gray’s Papaya (how do they get them so good — you don’t want to know).
For managers accustomed to certainty in NAVs generated by fund administrators, cryptocurrencies presented an entirely new set of problems that had to be solved.
But by sure hand of God, by staying on the sidelines, many traditional pension fund managers managed to avoid the destructive boom and bust cycle that would have obliterated their portfolios. Imagine telling your employees that 80% of their pensions were wiped out — the reality of course is that no pension plan would put 100% of their assets in any particular instrument — but the lesson is there.
Which is why pension plans have and should start considering an allocation in cryptocurrencies today.
Pss…can I interest you in a case for cryptocurrencies?
The initial hype cycle (hopefully) is well and truly behind us. Public awareness of Bitcoin and its brethren has never been higher and companies that are continuing to build and develop the blockchain infrastructure necessary to support the next digital revolution are laying the building blocks today.
For many pension funds, especially given their long term time horizons, the bets that they place in both blockchain companies as well as cryptocurrencies today have the potential to payout in exponential multiples in the long term.
And given the relative “cheapness” of investing in cryptocurrencies (the entire market cap of cryptocurrencies is barely US$120 billion (Ford wrote off US$877 million last year from their pension fund and spilled no blood) and blockchain companies today, pensions funds can hedge their allocation into these “risky” asset sufficiently to ensure that no particular point of failure will be significant enough to force a large write down.
Because just one good bet out of ten in cryptocurrencies and blockchain companies may have the potential to cover the losses from the nine losers and then some.
Unlike hedge funds, which often have fixed time horizons and have the pressure to deliver regular annualized returns, pension funds may have a unique advantage when it comes to cryptocurrencies and blockchain companies — the ability to smooth out the value of their portfolios, instead of taking a mark-to-market approach.
Cryptocurrencies and blockchain companies will need at least five to ten years to mature the technology and to pave the way for widespread innovation and adoption. That sort of time horizon, at a time when many of the Baby Boomers will be heading towards their retirement and drawing down on their pensions in large numbers, may be exactly the thing that the pension fund manager ordered.
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