Should European pension funds be invested in equities at all? With the gradual growth of an equity culture in continental Europe, and the increasing exposure of continental European pension funds to Eurozone and global equities it seems impertinent to even ask such a question.
Yet this is precisely what some corporate finance and investment officers in the UK are now doing. Their argument, simply stated, is that pension funds are taking unnecessary bets by investing in equities and they and their members would be better off in bonds.
The pension fund of the UK retail chemist Boots has already voted with its feet by moving the whole of its £2.3bn (e3.7bn) portfolio from equities into long-dated bonds. Other UK funds such as Corus and ICI are reported to be thinking along the same lines.
The switch out of equities was instigated by John Ralfe, Boots’ head of corporate finance. Ralfe questions the conventional wisdom is that equities out perform bonds and that this out performance reduces pensions cost. He says this equation only works if you ignore risk. By treating the equity premium as a free lunch rather than a reward for risk, pension funds are double-counting the benefit of being in equities.
Ralfe cites the Miller-Modigliani principle which says that, ignoring tax, changing a company’s debt/ equity mix cannot add value for a company’s shareholders. The increase in shareholder return from a company’s borrowing is merely a reward for taking a higher financial risk. He suggests the same is true of a company’s pension fund. Holding equities rather than bonds increases risk in the fund, and the return from equities is a reward for extra risk.
The risk pension funds accept is the significant risk of an asset/liability mismatch – the principal reason why Boots moved out of equities and into fixed income.
If pension funds are ignoring this risk, the rating agencies are not. Standard & Poor’s revealed last year that it was taking a harder look at the impact a company’s pension fund could have on the company’s creditworthiness. The risk to a company’s cash flow is the central issue. S&P has suggested that a company’s credit rating could be adversely affected if it had to pour large amounts of cash into its pension fund.
Chris Woods, chief investment officer at State Street Global Advisors in the UK, says there are several reasons why pension funds are considering moving out of equities and into fixed income. One is FRS 17, the new accounting standard for pension funds. Under FRS 17 a company will show in its own accounts the pension fund’s surplus or deficit, and any movements in its underlying value.
Another reason reason is the poor performance and prospects of equities. “There used to be a belief that equities will always outperform in the long run. Yet an ABM Amro study has shown that in four European countries – Germany, the Netherlands, Switzerland and Sweden – equities took 40 years to outperform,” Woods says. He also points out that, statistically, there is a one in six chance that equities will return zero or less over 20 years.
However, Woods suggests there is a third reason which could grow more compelling with time: pension funds can actully bring benefit to their sponsor or company by moving out of equities and into bonds: “If the pension fund sells equities and buys bonds then the company is better off because the cash flow contributions to the fund are more stable. If the cash flow to the fund becomes more stable the share price becomes more stable. If the share price becomes more stable, the company can, if it wants, issue debt and buy back its own shares.”

The reduced equity risk means that a company has more money Boots is using its improved cash flow to buy back £300m of shares from shareholders, funded from the company’s cash resources. This is exactly the same amount as the pre-tax surplus Boots reported under the FRS 17 accounting rule.
However, a key issue is the way in which the tax position in the UK favours the switch into bonds. UK chancellor Gordon Brown’s abolition of advance corporation tax credits in 1997 is likely to cost funds an estimated £40bn in lost tax repayments in the first 10 years from that change. On the other hand, pension funds can earn interest before tax from their bond holdings.
Woods concludes that the net result of the switch from equities to bonds is purely fiscal. The company has reduced its tax burden, and only the government – in terms of lost tax – has suffered. “The company may be less diversified, because it has bought its own shares back but the tax advantages offset the cost of this,” he says.
Irwin Tepper, founder of US-based Irwin Tepper Associates which specialises in asset/liability analysis for employee benefit programmes, has taken the argument further and suggested that individual shareholders can achieve the same result as a share buy-back by taking their money out of the company’s stock and putting it into the bank.
This is an extension of the Miller-Modigliani principle that, by investing in equities through the pension fund, the company is doing nothing that the individual shareholder cannot do directly. Indeed, it is more tax-efficient for the company or the individual shareholder to own the equities directly.
“This sort of thinking is not going to catch on just yet. An enormous amount of education will need to be done of trustees – and finance directors.” Woods also concedes that continental European pension funds are far from receptive to the idea: “This is not what they want to hear. Having just got into an equities culture they don’t want to be told by the Anglo Saxons that they have to get out again.”
Claude Chuard, a pension fund consultant in Berne, concurs: “Pension funds in the UK and the Netherlands, which are heavily invested in equities, always tend to exaggerate trends one way or the other. A Swiss pension fund we advise planned to sell all its equities and move into fixed income. We made an asset liability model and showed that this was a certain disaster. So now the fund has decided that instead it will move into fixed income gradually. That is merely postponing the disaster.”
However, some pension fund managers are prepared to give at least the theory a hearing. Jean-Pierre Steiner corporate pension and insurance director at the Nestlé pension fund in Switzerland, says: “It’s quite an interesting thesis that they Boots raise. It’s something I need to discuss more with our investor relations department, but what I’ve heard so far is that no analysts have raised the issue with us saying, okay, your stock price basically is penalised because the Nestlé pension fund takes a financial risk.
“So if someone could demonstrate to us that our multiple would be larger if Nestlé as a group would not run any risk on its pension fund assets, and that the boost to the multiple would be equivalent to the larger pension expense (because of lower returns?) then okay you should reconsider. But until then I’m not sure that it’s such a large risk that Nestlé’s stock market multiple is penalised by that much.
“It remains to be demonstrated. Analysts make very precise calculations but at the end of the day how it really influences stock valuation, I’m not sure.”