Restating doctrine of matching
Last year the £2.3bn (e3.5bn) Boots pension fund rocked the UK pensions world by putting “every last penny” into a long bond portfolio, as John Ralfe, head of corporate finance at the high street chemist chain and the man responsible for much of the thinking behind the strategy, puts it.
Following a review in 2000, a new investment strategy was adopted by the pension fund trustees to “reduce investment risk to an absolute minimum”.
Over a 15-month period a portfolio that had been 75% in equities and 20% in short term bonds, moved to one that is 100% in eight triple-A rated sovereign issuers, such as the World Bank, the European Investment Bank and EBRD. “As sovereigns with triple-A ratings, they present virtually no credit risk.” The bonds have an average maturity of 30 years and are 25% inflation-linked, providing a close match for the maturity and indexation of pension liabilities
These bonds are held in custody without any trading – a stance that must strike a chill into the hearts of the UK asset management industry. “Since there is no trading, the only thing we have to do is to reinvest the net income.”
Ralfe says: “The fund has turned conventional pension fund wisdom on its head. The cult of the equity has been has been embedded in UK and US fund thinking, for a generation. The outperformance of equities over bonds, or the equity risk premium, is something that UK companies apparently have been able to capture through their pension funds. But the idea the pension funds should hold bonds, not equities, is standard corporate finance textbook stuff going back some 20 years.”
Boots made the moves for four reasons. The first was to reduce the company’s financial risk by matching pension assets with liabilities, he said. “The pension fund creates the risk of a deficit, as pension assets do not move in line with the pensions liabilities. Any deficits have to be met through increased contributions by Boots.” The bonds in the portfolio now do move closely in line with the value of pension liabilities and this reduces the likelihood and size of additional contributions.
“By reducing risk off-balance-sheet, we can increase risk on-balance-sheet, by reducing our capital. Some months ago, Boots announced a £300m share buyback, as a direct result of the pension fund moves,” says Ralfe.
“A second reason was to fix the long- term pension contribution at about £50m annually in real terms. Having 100% matched bonds as it turned out – and this was more luck than judgement – brought in a surplus of assets over accrued pension liabilities.”
Ralfe points out that dealing costs and management charges are also reduced dramatically. Previously the costs were roughly 50 basis points a year on the £2bn-plus fund. “So what had been costing Boots £10m a year, is now reduced to £250,000 – as what we have now is a glorified custody operation.” But this also cuts down the very significant cost in terms of trustee and management time. “A whole swathe of stuff that the trustees used to have to do we no longer have to bother about. It cuts down the compliance and other red tape.”
Fourthly, matching assets and liabilities increases the security for scheme members, says Ralfe. “The value of the assets that will be there should be sufficient to meet all pensions, regardless of any movements in financial markets.”
Ralfe spells out the four corporate finance principles that underlay Boots’ strategy. First, pensions assets and liabilities are the economic assets and liabilities of the sponsoring company. “Secondly, investing in equities is a clear asset and liabilities mismatch and, thirdly, investing in financial assets has zero value. Finally, changing the asset allocation of pension funds cannot add value for shareholders.”
Tackling each of these points, Ralfe argues that, since pensions are deferred salary payable at retirement, they are liabilities of the company and not the fund, as the company will have to increase the contribution if the fund has a deficit and obtains the benefit of a surplus in terms of a contribution holiday. But the assets were legally ringfenced within the pension fund structure to stop the employer making off with them.
With 75% of UK pension fund assets typically in equities, while the value of their liabilities reflected movements in real interest rates, there is a resulting mismatch. “There is no correlation between the value of these liabilities and equities – they do not move in line.” So any surpluses could disappear very quickly, he warned.
The reason given for this high equity exposure is that returns are higher than in bonds over the ‘long run’. If this is true, he asked, why shouldn’t a company borrow £1bn, say for 20 years at 6%, and invest this in equities. With a long-term equity risk premium of 3%, it should make £30m a year in the long run. Most companies would never do this directly, so why do they it indirectly, through their pension fund?
Ralfe blames the accounting system for allowing companies to invest in equities through their pension fund, as pension assets and liabilities are off the balance sheet in an opaque way. “The gains and losses from the assets and liabilities mismatches are hidden. Current UK accounting gives the impression that pension fund equity investment, with its superior long- term returns from equities with a lack of volatility for liabilities is given.”
Volatility versus the liabilities is the price pension funds have to pay for higher expected returns, he adds.
On the third point, that investing in financial assets has zero value, he says “What I mean is that the expected cashflow, discounted at a risk-adjusted rate, equals the price.” The price of financial assets on liquid markets is adjusted for all information available and for all risk, so £1,000 of cash must have the same value as £1,000 of equities and £1,000 of bonds, otherwise it would be possible to arbitrage between them. “The equity risk premium is the return for extra risk, and to take a credit for that extra return without acknowledging the risk is a case of double counting.”
Ralfe next asks if changing pension fund asset allocation could add value for shareholders of sponsoring companies. “In the UK and US, companies own each other through their pension funds. Once you knock off these cross-holdings and other institutional shareholdings on behalf of individuals, we are left with private individuals owning shares. When I buy shares, I am buying direct exposure to equities of that company and indirect exposure to equities held by pension funds in the shares of that company. A private shareholder can adjust his or her portfolio by buying and selling for cash, say from a pension fund. The overall position is unchanged.” He asks if, by investing in the financial markets through pension funds, is the company doing anything that the shareholder cannot do directly. “If it is a good thing to invest in equities, we should leave it to the shareholder to do this directly. It is up to private individuals to make our decisions about asset allocation, not the company management.” The company should stick to adding value by buying factors of production and selling the resulting products or services and not by taking bets in the financial markets, he said.
Ralfe emphasises that the changes did not mean a closing of the Boots’ pension scheme. “New employees start in a defined contribution scheme, before moving on to the defined benefit scheme.” The fund is not mature, nor is it large in relation to size of the company, it is equivalent to a third of the market capitalisation of Boots. “We are not taking a tactical view on the state of the equity markets, though we did sell when the Footsie was around 6,000.” It was about matching assets and liabilities.
The company publicly supports the moves to FRS17 accounting standards: “but our move was driven by economics not accounting”.
Ralfe also comments on the inflation risk from holding bonds. Under UK law, pension funds have to index pensions in payment for inflation up to 5% a year. “But deflation is a risk, as pensions cannot be reduced in times of deflation. When we finished the switch last year we had about 25% of portfolio in index-linked bonds. Very recently, we have put in place £200m of index-linked swaps, which increases the indexed element to one third,” says Ralfe. “I am a great fan of the swap market as a way of making subtle adjustments to pension fund assets. What we have achieved is a mechanism whereby they are index- linked on the way up to 5%, but in the event of deflation cannot fall.”
Looking at what Boots had done from a pensions industry perspective, Ralfe reckons they have given the conventional pension wisdom a sharp reminder that the asset allocation should be driven by liabilities. “What seems to be happening is a continual move by UK pension funds from equities to bonds. Commentators suggest this may be 20%, over the next couple of years.”