Fifty years ago, George Ross decided to invest the reserves of the Imperial Tobacco pension fund in equities instead of bonds. Until that moment, the norm was that pension funds invested in bonds (Russian railways, for example). Slowly but surely, the 60/40 rule (bonds/equities) became the benchmark for asset allocation.
Two years ago John Ralfe of the Boots pension fund decided, as part of a longer-term strategy, to swap the entire equity portfolio for bonds.
Since then, investing in equities has been regarded more as a deadly sin than an act of prudent management.
In June 2003 the Harvard Business Review even published an article titled: “Pension Roulette. Have you bet too much on equities?” In this article the theory of total immunisation of liabilities via investing in (riskless) bonds is brought forward as a solution.
Is there really nothing new under the sun? What is right and what is wrong? Why this sudden drive for bonds? Is this switch feasible? And if we want to stick to equities nonetheless, under what conditions should we do it?

Why the urge for bonds?
The main cause of this new theory (or hype?) can be traced back to the following elements (the sequence seems of utmost relevance to me):
q An unprecedented bull market made everything possible.The bull market of the 1990s posted performances in the equity markets that were unprecedented. Everybody made money, the risk connected to equity investments seemed to have vanished and on top of this interest rates dropped considerably, making even bond investments extremely ‘profitable’. The returns of pension funds were expressed in double digits.
q‘Maverick’ risk pushed aside ‘fiduciary’ risk. Driven by the ‘maverick’ risk, the ‘fiduciary’ risk was pushed into the corner. Weak governance, herd mentality, helped and even reinforced by consultants, ALM models and asset managers, pushed everybody further in the direction of equities. The career risk caused prudent asset managers to forget the principles of risk diversification and made them allocate anything up to 80% of their assets to equities. Furthermore, a simple indexation of the portfolio allowed everybody to follow the mass hysteria in a smooth manner. The self-fulfilling prophecy was a fact.
q Capitalisation as a single goal in itself. This development received a warm welcome in society, where pay-as-you-go systems where heaped with all the sins of the world. The general introduction of capitalisation and investment in equities was going to solve every shortfall in the first pillar pension systems.
q A piece of the pie for everyone. All of a sudden the plan sponsor found himself in the fortunate situation where he could let the ‘pension profits’ flow back to the profit and loss account while at the same time lowering the future costs of pensions by translating historic returns (short term!) into expected returns. In other words: the more you invested in equities (adding risk at the same time) the lower the costs of the pensions would be. Employees also enjoyed the benefits of this game, by negotiating substantially higher pensions and guarantees. Many companies even financed their restructuring costs with these higher ‘expected’ returns.
q Disillusionment follows. At the same time, it was forgotten that the realised equity risk premium could be negative for years in a row (see the Ambachtsheer Letter of April 2003). This was combined with a stubborn general perception that cyclical markets were relics of the past. When it turned out that cyclical markets were here to stay, tensions between short-term goals and long-term obligations came to the surface.
q The flight to alternative investments. Because pension fund managers did not want to give up the high expected returns, necessary to keep the actuarial hypothesis intact, the search started for another cure-all. This quest resulted in sophisticated instruments such as commodities, private equity and hedge funds. To invest in these complicated asset classes, specialised know-how was required, something not present at every pension fund. On top of this it turned out that here also promises were not always kept.
q New regulations with a short-term focus become the norm. The new regulations, formulated in the golden years (in which negative returns were perceived as impossible) focused on a short-term horizon. All of a sudden fair value was the only yardstick for measuring the coverage ratio. The conflict between the short-term vision of the ‘analyst’ and the long-term vision characteristic of the liabilities side of a pension fund was a fact. This development was even strengthened by the wave of scandals that goes alongside the bursting of a bubble.
q And under-funding is a fact. Under-funding was a fact and a scapegoat needed to be found. The fact that equities received this qualification was made even easier by the fact that at the same time and in the period shortly after, bond yields surged, fuelled by a substantial interest rate cut.
This evolution served as a breeding ground for the theory that a pension fund should not add risk to the plan sponsor and instead should strive for a total immunisation of pension liabilities. Let us have a look at the consequences of this theory.

Is this theory feasible? Is it sensible?
If pension funds wish to immunise their liabilities via an investment in bonds, there are basically three markets that can serve them:
q Inflation-linked government bonds. The most important alternative is immunisation by investing in inflation-linked government bonds. This is the perfect benchmark for liabilities that in most cases are also linked to inflation.
The outstanding volume of these bonds amounts to E31bn. The total assets of European pension funds exceed E2.3trn, of which a rough 40% or E1trn is invested in equities. The numbers are clear and it will probably take a while before this market has gained sufficient substance.
q Corporate bonds. Let’s move then to corporate bonds. What we see here is that not only is volume a problem, but also the average duration is substantially shorter than the liabilities. Moreover, one can easily forget the default risk involved with corporate bonds. Or has the history of the Russian tramways, the American railways and gold mines slipped our minds?
q Government bonds. This market definitely has sufficient size but the question arises whether investing in government bonds is not an upgraded and expensive form of the pay-as-you-go system. Why use the expensive detour of a pension fund for this?
But let us make the effort to look into the consequences of allocating 100% to government bonds:
q Low return, thus higher premiums required. Such investment would imply that we are satisfied with an expected return of rounded 3.5% and that the funding ratio should be calculated on the basis of that figure. That would lead in a lot of cases to a considerable increase in liabilities and consequently extra premiums or decreasing promises. Moreover, when one reasons from an under-funded situation this would in most cases immediately lead to higher cost prices for the plan sponsor.
q An even more substantial under-funding. The massive sale of stocks by pension funds that is now taking place will inevitably put more pressure on current stock prices, consequently enlarging the under-funding problem. This is because individual investors (through investments funds or not) cannot create enough demand to maintain market equilibrium – not even by the individualisation of the pension ‘problems’. In Europe, one is not willing to shift on such a large scale the risk on to the individual’s shoulders to deal with the very necessary additional pension.
q And finally, a philosophical consideration. What would be the implications if we make the statement that an investment in equities will not deliver a risk premium?
Why would we still be investing in our own company? Isn’t that the same as throwing overboard the whole capitalist system?!
So it seems that the problem is not equity investment itself, but more the way in which it is taking place and is followed up.
If pension funds must invest in equity, what should the prerequisites be?
In that case we would still have to take the risk linked to an equity investment. It is not difficult to demonstrate the sense in this. The historical risk premium in the long term will remain positive, even after the recent correction of the markets. Is it not true that the ‘value arithmetic index’ for US equity is back to its highest point since 1998?
As an example I have taken the Belgian pension funds. Over the past 18 years they have attained an average annual return of 7.38% or, corrected for inflation, a real return of 5.13%, according to the BVPF, the pension fund association. They have achieved this with a moderately aggressive asset mix containing approximately 50% equity on average.
So what are the conditions to be satisfied?
When we do not want to repeat our historical mistakes, it seems necessary to me that the following conditions need to be fullfilled when one wants to deviate from benchmark investments in riskless bonds:
q Install a decent governance structure. The pension fund has to have at its disposal a governance structure that allows it to acknowledge and to manage the risks inherent in the investments.
The board of trustees should be composed on the basis of the necessary competences and not by people solely appointed because of what they represent instead of what they know. Moreover, the responsibilities of the board, the management and the consultants should be precisely determined and put down in writing.
The management, not the consultant nor the board, should warrant the daily management of assets. They should justify themselves to the board, creating the right area of tension to stimulate good management.
q Accept all responsibilities inherent in the possession of stocks. The capitalist model assumes that the shareholder exercises his or her rights through the general meeting. When that does not happen, one automatically creates a vacuum from which another party will profit. Therefore it is necessary that the institutional investor exercises the voting rights associated with its stocks. We are no longer in the era where people could only vote with their feet.
q Clearly define who bears the risks. Clear appointments have to be made of who in the end bears the risk of the investment policy. Far too often too much space for interpretation is left open and it is unclear who has to pay up in the case of under-funding – the sponsor via extra contributions or the employee via lower guarantees.
q Determine the correct expected return. The model needs to be supported by sound expected returns that are different from the extrapolation of recent historical returns. Be aware that long periods can come with a negative risk premium that need to be compensated by the ‘fat’ years. The zero risk bond benchmark might be the most appropriate.
q Define and manage risk. When one adds risk through a strategic asset allocation which contains other instruments than the ‘zero risk bonds’, one should have at one’s disposition the necessary tools for risk budgeting and monitoring. What one cannot measure, one cannot manage.
q Measurement needs to take place consistently and continually, corresponding with predefined objectives. The predefined strategic asset allocation needs to be continually guarded in favuor of the risk budget. The results of this measuring process need to provide guidance to the strategic and tactical allocation.
q The elementary technique of diversification. A good currency overlay programme and the new structured products and hedge fund strategies can prove to be a useful instrument.
q Regulation. The above mentioned conditions are more or less under our own control. There remains one important condition that falls outside of this control – regulation. Besides an excellent knowledge about the existing regulation it is also logical that a regulation based on the short term can impose important restrictions to the risk budget. The financial capacity of the plan sponsor and the will and knowledge of all parties to accept the consequences of the risk, can be enhancing or restricting.
Equity had and still has a place in the asset allocation of a pension fund. However, if one wants to invest in equity then the pension fund should have at its disposal a good governance structure, it should make realistic assumptions concerning expected returns and it should install and monitor risk budgets. Decent diversification and the use of techniques such as currency overlay, structured products and hedge funds can have an important added value to better match the risks, expressed in function of the ‘short-term’ regulation, to the, preferably already agreed upon, financial capacity of the plan sponsor.
Karel Stroobants is chairman, advisory board, FundPartners, in the Netherlands

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