UK – FRS 17, the new accounting standard for pension funds in the UK is causing dramatic shifts in portfolio composition, says an equity research report by Deutsche Bank (DB).
The report also warns that UK entry into the euro could have an even more damaging effect on domestic demand for UK equities among pension funds, since the domestic weighting of UK equities would fall since the Euroland would become the domestic market.
The report suggests that equities have been in steady decline since the early 1990s and that the introduction of FRS 17 has played its part in several different ways :
•fund values have been reduced by falling equities values
•financial accounts will now take account of the volatility of equities
•the matching liability for assets is corporate bonds
•the increased cost of pension fund provision will reduce corporate earnings and affect equity returns.
Other reasons for the shift suggested by Deutsche Bank include low inflation driving down returns, the global equity market slowdown and the fact that equity portfolios are more expensive to run than bond ones.
The study points out that while UK pension funds are reducing the level of equities traditionally at 70% of portfolios, other countries are increasing theirs, as equity portions across continental Europe have doubled in the last five years to almost 40%.
Corporate bonds now constitute the fastest growing asset class in the UK, says the report, with cash flows in 2000 from them of £30.5bn (€48.5bn), which represents 38% of the total cash flow that year. The move to bonds started with the introduction of the minimum funding requirement (MFR) in the 1990s following the Maxwell affair.
But the problem of making a significant switch to bond heavy portfolios is that the supply of such assets is relatively modest. Deutsche Bank points out that the latest figures issued by the Debt Management Office, which is an independent operating arm of the UK Treasury, show that outstanding gilt supply is £300bn, whereas institutional assets in the UK total some £2,000bn. Funding positions may become even more difficult if portfolio changes push bond yields further down.