EUROPE- FRS17 and falling equity markets are leading UK and Eurozone pension funds to take a more conservative approach to their asset allocation, to switch from equities into bonds and to cut their cross border holdings in favour of local assets according to research by State Street Global Markets (SSGM).

Avinash Persaud, global head of research at SSGM, says that FRS17 and falling equity markets have combined to produce “a fairly unholy cocktail.” Those particularly affected by the two are defined benefit schemes where the investment risk and liability lies with the employer. Older companies with pension funds that are large relative to their earnings are also particularly at risk.

Persaud estimates there are about two dozen funds in the UK alone whose structures put them in this type of predicament. Typically they are large and old companies that have downsized and of those two dozen, he estimates six are probably have a shortfall they need to meet.

“What FRS 17 has done is focus the minds of corporate treasurers as to potential problems it has given them an open-ended risk. What corporate treasurers are concerned about is the possibility of dividends having to be cut,” he says.

Pension schemes are therefore reducing their equity holdings, increasing bonds and taking a more conservative approach to their asset allocation. Only this week, the £40m (e65m) pension fund of department store operator James Beattie announced its surplus had fallen from 129% to 111% and that it had subsequently cut its equity exposure from 80% to 70%.

Persaud says another motive often overlooked at the moment is that pension funds are simply trying to reduce overall risk. “Consequently they are going to go from oversees to local assets and they are going to reduce currency exposure as they are trying to match assets and liabilities,” he says.

The rebalancing is likely to be most acute in the UK, home of a strong equity culture where it’s not unusual for pension funds to have 75% in equities and, of those, 30% abroad. Persaud says this will affect capital outflows and it raises the issue of the insufficient UK corporate bond market. Put simply, he says the Stirling bond market is not big enough to meet demand at the moment.

As a result, it is likely that foreign institutions will begin issuing in the UK. “They do not need the sterling and will only be issuing because there’s demand. They will probably take the Stirling and convert it back to another currency creating an outflow again. If UK companies are unable to increase their issuance substantially, the capital outflow will still be there,” he says.

Persaud is convinced that developments in the UK are going to be very similar to Europe since the man who chaired the committee that dreamt up FRS 17 has taken up a similar position in Europe. “I think you’re likely to see Europe take some very similar steps.

“After years of diversification, of increased overseas exposure, we are actually seeing a return to very conservative money management,” he says.