Since the 11 September terrorist attacks, world stock markets have been turbulent and as we near the end of the year, many pension fund trustees and plan sponsors are understandably asking whether they should be taking action.
Although the initial ground lost has been recovered, investors in developed countries have seen one of the worst years for equity returns since the inception of quoted stock markets. Equity markets peaked at the end of August 2000, and since then the World Index has fallen by around 30% in sterling terms. Government bonds have held up well, with the result that equities have underperformed sovereign debt by around 40%. This has had severe consequences for pension fund solvency.
More recently, the well-publicised decision by Boots in the UK to switch its entire £2.3bn (e3.7bn) pension fund into bonds will add fuel to the investment strategy debate.
It is clear that a panic switch out of equities into bonds soon after 11 September would have been worse than doing nothing. Short-term tactical switches of this nature are as likely to lose money as they are to add value. But should trustees and plan sponsors now be reviewing their long-term strategic asset allocation?
Most fund managers and analysts have published their responses to the 11 September attacks. The broadly held conclusions are:
o The fall in consumer confidence as a result of the attacks will reduce economic activity in the short term. The US is already in recession
o The swift and committed response by central banks and governments should stimulate the economy in the medium term
o There are obvious negative consequences for certain industries, like hotels, airlines and insurance. However, there are differences of opinion as to how far these stocks ought to have fallen to fairly reflect their diminished earnings potential
The general view is that the 11 September attacks were a temporary setback to the economy. One might speculate as to how long it will take for the fiscal and monetary intervention to work, but the widespread view is that the US economy is fundamentally sound.
Crucially, economists and fund managers are not likening the US today to Japan in the late 1980s. Japan had (and still has) structural problems that stem from the role of the government and the lack of effective adjustment mechanisms in the corporate sector. In Japan, unprofitable companies were not allowed to fail and they have not (until very recently) cut costs by laying off staff. Companies have not been run in the interests of shareholders and there has not been an effective mechanism for stopping management making poor decisions. The inflexibility of the system has meant that painful, but necessary decisions have been avoided.
America is different, and already it is clear that the industries hardest hit by the attacks have taken steps to react. The structural problems that make it difficult for Japan to emerge from its recession do not exist in the US. Consequently, so the economists argue, fiscal and monetary measures should help the economy recover.
The single most important investment decision for trustees and plan sponsors is the equity/bond split. Many funds will have used asset-liability modelling to help take this decision. There are two important inputs to this process that might have changed:
o the risk and return assumption for equities and bonds, and
o the willingness and ability of the sponsor to support the current equity weighting.
Equities provide less certainty than bonds. Investors only hold equities in preference to bonds if they expect them to produce better returns in the future. Therefore equity markets fall when:
o expectations about future earnings are revised downwards – stock markets fall to the point such that the future returns (from a lower starting point) are large enough to incentivise investors to continue to hold equities rather than other assets, and
o the uncertainty surrounding future equity returns increases – if equities become more risky relative to other, safer assets, equity markets fall relative to bonds so that the expected future returns rise high enough to compensate investors for the greater risk of holding equities.
It is important for investors to distinguish between the falls that have already taken place and the expectation of returns in the future. With the benefit of hindsight it would have been ideal to switch from equities into bonds just over a year ago. That missed opportunity should not drive expectations of the future.
One way to develop forward-looking expectations of equity returns is to use the dividend yield model, which states:
Expected real equity returns =
Dividend yield + Real dividend growth
The dividend yields for regional equity markets are objective figures, but the real growth assumptions are clearly subjective. The table shows the figures using real growth assumptions currently proposed by one fund manager. Other fund managers and economists will have different views, but for major Western equity markets, most commentators will suggest a forward-looking real return assumption of 4.5–5.5% pa.
UK index-linked gilts provide a guaranteed real return of around 2% pa, so an equity risk premium (the expected outperformance of equities over bonds) for UK equities of around 3% pa could be justified. The same analysis would suggest a lower equity risk premium for US and European equities.
Some modellers may make changes to their asset-liability assumptions in the light of recent events. However, it is unlikely that these changes, in isolation, would result in a very different strategic asset allocation for pension funds.
Most final salary pension schemes rely on a sponsor to pay for benefits that cannot be met by the assets. Ultimately the sponsor would be called upon to make good investment losses and it therefore has a real interest in determining the investment strategy.
However, at least in the UK, it is the trustees that set investment strategy, and whilst it is appropriate for the trustees to consider the sponsor’s willingness to support the investment strategy, it is far more important that they also consider the sponsor’s ability to finance any deficits.
It is difficult to generalise as to how the sponsor’s position may have changed following 11 September. Clearly some companies are under tremendous pressure, and do face a real prospect of bankruptcy. In these circumstances the trustees may need to consider drastic action.
However one factor that will affect many UK pensions schemes is the impending introduction of the new accounting standard, FRS17. FRS17 will encourage fund managers, analysts, bondholders, rating agencies and banks to start questioning company management about the pension fund. In many cases this will be the first time that company management will be asked to explain how the pension fund investment strategy, and the risks and rewards it entails, affects these stakeholders. This should cause company management to take a closer interest in the pension fund investment strategy, and apply similar analytical techniques to those used to appraise other corporate decisions.
Although the European accounting standards are ‘weaker’ than FRS17, as fund managers gain a better understanding of the costs and risks implied by final salary pension funds, they will surely start asking similar questions to European companies. It is this increased focus on cost and risk that is likely to influence the pension fund’s investment strategy, rather than the technical details of the accounting treatment.
It is quite possible that, like Boots, many sponsors will come to support a different investment strategy once they take these considerations into account, and it would make sense for trustees to open this dialogue sooner rather than later.
It would be unwise for pension funds to adjust their asset allocation simply in response to market volatility, as they are just as likely to get the timing wrong and make matters worse.
Although some asset-liability modelling assumptions may have changed over the past year, this is unlikely in itself to lead to a very different strategic asset allocation. Equities still offer an expected outperformance (or risk premium) over bonds.
However, it is possible that the sponsor’s willingness or ability to support the investment strategy may have changed, and it is important for trustees to open dialogue with plan sponsors to explore these issues.
Kerrin Rosenberg is a partner Bacon & Woodrow in London