One of the City's best-kept secrets was

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					Business Pensions & Investment

Equity investment by a
pension fund makes no
difference to a company’s
value. Trustees should
learn from this, avoid
unnecessary risk and
instead provide scheme
members with a secure
future. John Shuttleworth

       ne of the City’s best-kept secrets was         does not match each future year’s pension             that equities had begun to look risk-free and all
       finally leaked last October. Known only        outgo is the same as trying to improve your           trustees had concluded they were financial
       to a few, between the spring of 2000 and       household’s finances by stopping your fire            geniuses. The bell rang in the spring of 2000,
July 2001, the Boots pension fund had quietly         insurance. To be sure, your cash flow is better –     but it was not heard until much later.
transformed its equity/bond split from a con-         until your house burns down.                            It often comes as a surprise to the British to
ventional 75/25 to a purist’s 0/100.                     This failure to add to shareholder value is a      learn that the continentals want little to do with
   Boots had two motives, both laudable: to           galling thought for those who make a living out       our private sector pension system. And those
improve the security of its employees’ pensions,      of pension fund investment. And for company           who doubt this caution need look no further
and to reduce its shareholders’ risk. The technical   management and trustees, the sobering con-            than the awkward reality that the pension funds
analysis was impeccable: a business’s liabilities     clusion seems to be that the best strategy is one     of this country’s insolvent companies are
(here, to pay pensions stretching out decades         of masterly inactivity. Complex equity/bond           almost always insolvent themselves.
ahead) should be hedged with investments with         portfolios merely soak up management time.              Trustees too easily forget that the distinguish-
similar characteristics (here, long bonds).              One can only speculate about how other             ing characteristic of insolvent companies is that
   Media comment has focused on whether               trustees will respond to Boots’ black and white       they have no money. They need to think far more
other pension funds will follow suit. It seems        analysis. A more useful line of inquiry is why,       carefully about how crucial the company’s well-
inevitable that the huge equity content in UK         back in the spring of 2000 when many pension          being is to their pension fund’s solvency. The
pension funds’ portfolios will gradually fall. The    funds had healthy surpluses, few other trustees       man in the street does not expect to be exposed
wags will no doubt say that this decremental          had on their agenda the possibility of crystallis-    to double jeopardy – his job and his pension.
risk-reduction will not be unlike the 12-step         ing their surplus. How was the plot lost? The
process of Alcoholics Anonymous. Indeed, an           reasons are numerous and complex:                     Shared interests
immediate fall seems unlikely.                        s Most trustee boards lack in-depth invest-           In short, trustees’ charmed life has drawn to a
                                                      ment expertise – the key criticism of the             sudden close. The next generation of trustees
Quit while you’re ahead                               Treasury-sponsored Myners inquiry.                    will be more accountable to their different
And with good reason. The Boots trustees land-        s Investment consultants, overly concerned            stakeholders and, where they choose to take
ed on their feet and crystallised a surplus. Other    about their own business risk, rarely put forward     risk, will have to clearly articulate why.
trustees are now nursing deficits as a result of      ideas that UK pension fund trustees are not           Stakeholders will demand nothing less. Sadly, it
the significant decoupling of equity and bond         embracing already. Remember: the action Boots         may yet need a court case to demonstrate that
markets since the top of the bull market in           took was instigated from within (by its corporate     some trustees’ investment strategies are, in
March 2000. In gambling parlance, the Boots           finance department, not its consultants).             financial terms, bordering on the reckless.
trustees quit while they were ahead. It is not at     s Most trustees simply do not understand the             Boots executed a bravura full-frontal assault
all obvious that Boots would have done what it        degree of risk-taking in their investment portfo-     on the many vested interests surrounding the
did had there been a deficit. Arguably what was       lios. Again, the Myners inquiry says this derelic-    pension fund honeypot. And it was wonderful to
most noteworthy was what didn’t happen –              tion has to change. By all means, take a risk –       watch! The big surprise is that, counter-intuitive-
over the fortnight spanning the leaking of the        but only if you know how much.                        ly, the interests of members and shareholders
news, Boots’ share price hardly moved.                s Trusteeship in this country is a part-time activ-   have turned out to be one and the same. People
   So we now know the answer to what the              ity, performed in the main by amateurs. From          will chew on this paradox for a long time. A
theorists have long contended – equity invest-        genesis to implementation, a decision can take
ment by a pension fund makes no difference to         months, and on occasion years, to implement.           John Shuttleworth is an actuarial partner at
the value of the business. According to the           s Self-delusion – everyone wants their free            PricewaterhouseCoopers
investment textbooks, any investment that             lunch. The bull market had gone on for so long

Accountancy January 2002
Business Pensions & Investment

                                                             DON’T MENTION
                                                             THE GERMANS
                                                             The UK is still not taking the necessary action to
                                                             safeguard pension funds. It’s time we followed the
                                                             example of others, says John Shuttleworth
                                                             who overspend on their credit card? It        government-sponsored reports that address
                                                             seems that the normal laws of credit do       the pension security problem. The real oddity
                                                             not apply to Latin American economies         in both was the paucity of reference to non-UK
                                                             or UK companies’ pension promises.            practice: five pages in the 1993 post-Maxwell
                                                                The insurance approach used in             report and two pages in Paul Myners’ report last
                                                             other countries is casually dismissed in      year. It is a case of don’t mention the Germans –
                                                             the worst sort of half-baked Whitehall        or the Swedes or the Americans or the
                                                             conceptualising. It is asserted that pen-     Canadians. In all these countries, insurance
                                                             sion fund investment choices would            makes good deficits.
                                                             become ‘distortionary’ (not a feature           How much would an insurance solution cost?
                                                             the Americans would recognise in their        Overseas experience suggests about one-fifth of
                                                             allegedly ‘distorted’ pension plans).         what the British spend on house contents
                                                                Instead, pension schemes are to have       insurance. This is hardly lavish – pensions are,
                                                             a ‘long-term scheme-specific funding          for most people, either their biggest or second
                                                             standard’ (whatever this gobbledegook         biggest financial asset, and are therefore a
                                                             might mean). And putting beyond               prime determinant of one’s quality of life.
                                                             doubt the suspicion that Whitehall

       fter the debacle of the minimum funding       makes it up as it goes along, the government          Whitehall whitewash
       requirement, the British are getting a sec-   has binned an earlier idea of making good             Since Whitehall is in a minority, one needs to
       ond chance at solving the pension securi-     deficits within ‘a relatively short period of time,   look for a motive. A number spring to mind: the
ty problem. And it looks as if they will squander    say three years’. The talk is now of 10 years.        Treasury was undoubtedly humiliated by the
it. The British are in a fix. Almost always, the                                                           MFR debacle and is wary of getting it wrong a
pension funds of insolvent companies in this         Cover-up                                              second time. Hence the attraction of deregula-
country are themselves insolvent. The MFR was        Fundamentally, the British need to decide what        tion – it becomes someone else’s problem. Any
a Heath-Robinson contraption designed to do          level of consumer protection should be given to       form of insurance is likely to lead to a reduction
something about this. It fell over for numerous      individuals’ pensions. There are precedents.          in UK pension funds’ chunky equity holdings.
technical reasons but, fundamentally, it had to      Insurance company products are covered. And,          The Treasury wants to inculcate an equity cul-
go because it did not deliver – the employees of     in a strange example of the prioritisation of         ture in the country’s savers. Whitehall does not
an insolvent company with a 100% MFR funded          what is important in life, the British public is      have the appetite to construct a quasi-govern-
scheme receive only 60p to 70p in the pound.         protected against the insolvency of travel oper-      ment insurance system along the lines of those
   Every other country that has looked at the        ators. Yet pension funds are covered only             found abroad.
pension security problem has found the same          against fraud – something that happens rarely.           It is just possible that Whitehall is right and
answer. First, companies should stand by pen-           If you liken pension schemes to a fire service,    the rest of the world is wrong. If so, the Treasury
sion promises that they have voluntarily             a single fire engine for the whole country, avail-    is in for a busy time as other countries come
entered into. Only in the UK can an employer         able to put out fires in all pension schemes, is      here to study the British way before returning
unilaterally substitute something of lesser          the basis for the US and German model. A sin-         home to unwind their own arrangements. More
value. Second, some insurance system should          gle fire engine, without wheels, that takes a year    probably the next few years will see the British,
ensure that pensions are paid in full in the         to get on the road, is what the British have at the   true to form, muddling through.
event of the employer’s insolvency. This is what     moment. One fire engine for each pension                 This is a debate that will not go away. People
happens in Germany, Sweden and the US –              scheme – the fiscal equivalent of every pension       do not want double jeopardy – losing both their
tried and tested for 25 years.                       scheme being amply funded against even the            job and their pension. Brussels has made it
   Perversely, Whitehall is resisting on both        remotest outcome. This cannot be the opti-            clear that it wants all EU pension funds to have
counts. It has backtracked on a March 2001           mum use of UK plc’s shareholders’ funds. No           sufficient money to pay pensions at all times.
statement that ‘companies must meet in full          sensible business denies itself the use of insur-     Either Whitehall will introduce change volun-
the accrued entitlements of scheme members’,         ance. This is the nub of the problem – pension        tarily, or Brussels will do it for them. A
now asserting that this ‘could be unsustainable      promises are only as strong or as weak as UK
for many UK companies’. When you stop and            industry itself. Business uses insurance               John Shuttleworth is an actuarial partner at
think about it, this is really quite odd. Would      because it makes business more efficient.              PricewaterhouseCoopers
Parliament allow the same behaviour by people           In the last 10 years we have had two major

Accountancy .ebruary 2002
Business Pensions & Investment

No pay, no gain
The UK spend on state pensions is half the EU average, there is no clear strategy and
the poor are losing out. The government should follow the examples of our EU
counterparts, says John Shuttleworth

    t is almost axiomatic that when the bureau-          cations of this division into haves and have-         vehicle that is cheap. It is no exaggeration that,
    cracy touches pensions, the result is legisla-       nots. Worryingly, it always seems to be the next      before stakeholder, commission and other costs
    tion of bewildering complexity. This is what         government’s problem. Suppose we did have a           more or less cancelled out the tax-relief. Second,
will happen in April when the state earnings-            grand design. What would it look like? The ‘to        there is a very good reason why the poor are not
related pension scheme (SERPS) is rebranded              fund or not to fund’ debate is a sideshow. But do     buying more pension provision – they have no
the state second pension (S2P). And a year from          not underestimate the politics – supporters of        money to save.
now, the new ‘pensions credit’ will means-test           funding often seem more motivated by a desire
the state pension. The sometimes weird, but              to build huge piles of investments than how to        Not so simple
always fiendish detail is probably fully under-          deliver a no-frills state pension in the most effi-   It is easy to argue that government’s role in pen-
stood only by a handful of civil servants – who          cient way.                                            sion provision should be limited to providing a
will quickly forget it when they rotate to the next         It cannot be repeated enough that pre-fund-        low quality pension and the creation of a sav-
department of state.                                     ing the state pension does not magically make it      ings environment in which people can reliably
   The British have not had a pension strategy           more sustainable. No matter how cleverly the          plan. But real life is not so simple. The reason for
since the 1950s – hence the jibes that the govern-       economic cake is cut, a country’s economic pro-       the periodic revisiting of UK public policy on
ment makes it up as it goes along. As with our           duction in any year is consumed by the people         pensions is that in the UK, much more than on
railways, policymakers seem bedevilled by                who are then alive. The issue is how different        the continent and in North America, the poor
chronic indecision. This is slightly unfair – in the     generations lay claim to each year’s production.      are excluded.
last few years, there has been a clear policy intent     (And pre-funding does not even guarantee pay-            It must be a pretty good bet that, by the end of
to retarget the state pension at the lower paid.         ment – as irate Argentinians have just discov-        the decade, Whitehall will be back from the
   There is undeniable logic to what the govern-         ered. To stop a run on the banks, their govern-       drawing board with a proposition that, just as
ment is doing – it is surely a proper role of gov-       ment has said it will unilaterally convert all bank   everyone must pay taxes, each of us must con-
ernment to deliver a defined benefit pension to          deposits made by pension funds into govern-           tribute to an individual DC savings account. A
people who have a low risk tolerance. The                ment debt.)
unpredictability of defined contribution makes              An emerging model in many countries is a            John Shuttleworth is an actuarial partner at
it unsuitable for the poor. Dickens put it more          core defined benefit (DB) pension with individ-        PricewaterhouseCoopers.
elegantly: ‘Annual income £20, annual expendi-           ual defined contributions (DC) accounts on top.
ture £19 19/6d, the result happiness. Annual             The Germans are the most recent to embrace
income £20, annual expenditure £20 0/6d, the             this. From 2008, UK-style personal pensions will
result misery.’                                          be available to which individuals can contribute
                                                         a tax-deductible 4% of pay.
British cheapskate                                          At the beginning of this decade, the Swedes
The government is keen to boast of the UK’s low          introduced a state system that is genuinely
spend on state pensions. It is already the lowest        innovative. Under its DB core, each Swede has
in the European Union (half the EU average, at           an individual account to which 16% of their pay
just 5% of GDP). In spite of our adverse demo-           is credited each year. This account is revalued by
graphics, we are the only member state where             wage inflation. Then there is a DC top-up, to
the spend is expected to fall over the next few          which 2.5% of pay is paid.
decades. Some boast!                                        The Swedes have been pragmatic about the
   Like families that only reluctantly mention           design of their DC arrangement, constructing a
the miser amongst them, the continentals rarely          sensible public/private partnership. Keen to
refer to the British cheapskate approach to pen-         avoid the high costs of administering individual
sions. And with good reason – we have failed to          DC accounts in the UK and other countries, the
make cheap labour costs a competitive advan-             Swedes set up a publicly-owned clearing house.
tage. Yet this failure is easy to explain. To be sure,   It negotiates charges with in excess of 80 invest-
our spend on state pensions is half the EU aver-         ment managers, collects contributions, pays
age, but all that is happening is that the half of       them to the managers, and maintains records.
the UK workforce who are not in tax-subsidised              In the UK, stakeholder pensions have been
occupational pension schemes are losing out.             sniped at and labelled a flop – in the first eight
On pensions as a whole, public and private               months since their launch ‘just’ 570,000 were
together, we spend roughly the EU average.               bought. The snipers miss two points. For the
   There are potentially profound societal impli-        first time, the British have a long-term savings

Accountancy March 2002
                                                                                                          Pensions & Investment Business

Heading for a fall
The risk involved with investment in equities increases
over time. Too many trustees ignore this fact and
put pension funds in jeopardy, says John Shuttleworth

       here are many misconceptions in invest-        the rudiments of investment. But in
       ment, but the mother of them all is surely     the case of pension fund trustees, it
       the common belief that equities become         does matter because they invest
less risky the longer you hold them. Exactly the      other      people’s    money.     Paul
reverse is so. Since any good book on finance         Samuelson, arguably the pre-emi-
tells you this, it is both puzzling and worrying      nent economist of the second half of
that this popular myth endures. To be sure, the       the 20th century, has described it as ‘a
longer you hold equities, the more likely they        blunder if not a crime’ for a fiduciary
are to outperform cash or bonds. But this analy-      trustee to believe that equities’ risk
sis is only one dimension of a two-dimensional        decreases over time.
picture. What is missing is the size of the short-       If you strip away the wrapping on a
fall when equities underperform.                      pension fund and look at its financial
   If you put the two dimensions together, the        fundamentals, you find yourself look-
mathematics shows clearly that equities’ risk         ing at a hedge fund (to get technical,
increases, not decreases, the longer they are         one that is short bonds and long
held. (Technically, you use the methodology of        equities). Pension fund trustees in
option pricing to calculate what an investment        this country simply do not get this.
bank would charge to insure your equity port-         The terrible events of 2001 reminded us that the     If you strip away the
folio against underperformance. Answer: the           world remains a risky place. This is why equities
longer you need the insurance for, the more you       probably outperform bonds. But this is a state-      wrapping on a pension
get charged, reflecting the fact that the risk per-   ment of no great insight. After all, junk bonds
sists.) To be sure, the investor buying equities      probably outperform gilts (but not certainly,        fund and look at its
for the long haul has more time to recover from       and not all the time). Challenge: if you are one
market collapses, but he also has more time to        of the believers, why stop at the herd’s 75% in      financial fundamentals,
encounter them.                                       equities; why not go all the way to 100%?
   To reassure readers of the credentials of these    Answer: if it were guaranteed that equities
                                                                                                           you find yourself looking
assertions, I hasten to add that all are endorsed     would outperform, their price would rise to
by the investment gurus – Bodie, Merton and           eliminate the arbitrage opportunity.
                                                                                                           at a hedge fund
Samuelson to name but three (and the last two            This is not to say that trustees should not       the thrust of this article. It has not been my
are Nobel prize winners).                             continue to invest in equities; rather, trustees     intention to annoy. The hopelessly poignant
   Not unreasonably, pension fund trustees in         need to work harder on their logic. This is that     thing is not trustees’ naïve belief that the top
this country are not keen on this analysis – they     the sponsoring company’s management asks             has yet to come, but that so many trustees
point to the last century and the absence of any      them to run a heavy asset/liability mismatch.        believe so vehemently that their efforts are
20-year period in which UK or US equities did         Trustees clearly cannot have a higher risk toler-    well-intentioned.
not outperform bonds. But this data is thread-        ance than the company, but they could have a            The English have a fondness for amateurs
bare, to say the least. The last century contains     lower one. More often than not, though,              and eccentrics. Both scare the continentals. My
just five independent 20-year periods. No stat-       trustees conclude that the company’s under-          proposition is that amateurism is not good
istician would draw anything but the flimsiest        writing of the mismatch is good enough.              enough for pension fund members. Paul
conclusion from five data points.                                                                          Myners, to his credit, confronted this last year
   Advocates of the equities free lunch also con-     Lost plot                                            and the law is shortly to be changed to put
veniently forget Japan’s travails, and that some      Yet events repeatedly prove this to be an opti-      beyond doubt that decision-makers must be
stock markets have disappeared entirely               mistic conclusion – the pension funds of this        ‘familiar with the issues’. The Treasury has said
(including those in Russia, Peru and Poland).         country’s insolvent companies are almost             the current position is a ‘matter for serious con-
Survivorship bias is the oldest pitfall of them all   always themselves found to be insolvent.             cern’. Let’s hope trustees can make this step-
for the amateur statistician.                         Trustees too often forget their job – to protect     change before the failure of a very large pension
                                                      employees against double jeopardy (their job         fund brings the debate into the courts.
Ignorance is not bliss                                and their pension) – and try to second-guess         Somewhere along the way the plot got lost –
Does this lack of knowledge among investors           what the company wants. And company man-             pension funds are there to provide pensions. It’s
matter? Yes and no. In the case of private            agement has a case to answer too: it can under-      as simple as that. A
investors, you cannot legislate against igno-         estimate the virtues of a well-funded, safely
rance. Fools will always be separated from their      invested pension fund if the day ever comes           John Shuttleworth is an actuarial partner at
money. That said, we owe it to our children to        that the company downsizes.                           PricewaterhouseCoopers
give them a better education and grounding in           I am sure that many trustees will challenge

                                                                                                                                  April 2002 Accountancy