Boots the Chemists stunned the corporate world seven years ago by switching all its pension fund’s equity investments into bonds. Its decision reflected both pessimism in the prospect for shares and the impact of accounting standard FRS 17, which requires companies to declare pension fund liabilities on company balance sheets, based on current market values.
Life has moved on since Boots’ decision – the business is not even a listed company now, having been bought by the KKR private equity fund. Boots has also varied its pension fund’s asset allocation policy a bit more in subsequent years. But from the rear view mirror amidst the most severe stock market crisis since the Great Depression, the move looks to have been rather smart.
A very different approach has been taken by local government. While much of the private sector has reduced its equity exposure, local government pension schemes have retained theirs. According to figures produced by the National Association of Pension Funds, while British company schemes have a 24% exposure to UK equities, 30% of the value of local government schemes is in UK equities. The figures are even more stark with overseas shareholdings: the private sector has 14% of its pension fund assets in foreign equities, against 23% with UK local government. Local government schemes are also more heavily invested in private equity.*
The explanation is not that local government has more confidence in capitalism: rather it is that it can take a longer-term view. Nor does it have to worry about the impact of possibly temporary pension fund deficits on company profits and its share price.
But some scheme advisors believe that local government has become over-exposed to equities and needs to follow the private sector lead by moving more heavily into bonds. Ken Barker, director of the fixed income product group at investment managers Baillie Gifford, is one who is strongly advising local authorities to increase their investments in bonds, especially now. His argument is simple – price and yields. “We are not necessarily claiming that equities are expensive at the moment,” he says. “In fact, the house view is that they are cheap at the moment following the sell-off.” But, he argues, bonds are exceptionally good value at present.
“You can argue that several asset classes are cheap, but nothing else is as cheap as bonds,” Barker suggests. He quotes Deutsche Bank analysis which calculates that bond pricing assumes in the region of a 40% default rate amongst companies issuing bonds. Such a default rate would be astonishing, says Barker. “That would raise questions about whether capitalism itself would survive. I genuinely find it difficult to believe that we will get anything like 40% of our companies wiped away over the next five years. The worst we have had [in a recession] is a 2.5% loss.”
But says Barker, it is not simply a matter of selling shares to buy bonds. “We would not advise that people sell equities at this stage,” he explains. Instead, funds that have built-up cash holdings as a safety net in current market volatility should consider using this to increase bond holdings, Barker suggests. Returns on cash deposits are already poor and will continue falling as base rate cuts continue and feed through into the market.
Tim Sharples, a director of actuaries Lane, Clark and Peacock, says that whether the current balance of equities and bonds is right or wrong, it is “probably the wrong time now” to reduce equity exposure. But, he agrees, “as the market changes it is probably an opportunity” to reconsider the balance.
Sharples accepts that local government can take a longer view than can the private sector in terms of generating sufficient returns to cover liabilities, but he believes it is wrong to overlook the pressure on local authorities to increase contributions when funds go into deficits. Consequently, fund managers can expect more demand from politicians to reduce the volatility of funds, which inevitably means reducing the exposure to equities, moving instead into gilts (government bonds) and corporate bonds.
“They [local authorities] do have to think about how they are funding their pension schemes and make statements about how they are doing this,” says Sharples. “There will be pressure on local government to up their contribution rates in the short term.” This will involve finding extra funds from either higher council taxes, or service savings. As a result, councillors will increasingly see a link between high equity exposure and the need to raise contribution rates.
“I think with the benefit of hindsight it’s easy to say there should have been [a move from equities to bonds], but there were good reasons not to have done so,” says Sharples. “The question is what attitude to risk should they be taking?”
A similar point is made by Bob Summers, chair of CIPFA’s pension panel. “The way into this isn’t initially to concentrate on bonds versus equities,” suggests Summers. “It’s to think about the liabilities. Best practice is to look at an asset/liability modelling exercise and from that discuss with your trustees the shape of future liabilities and the risk levels they will be happy with and from that evolve an investment strategy which will determine how much you put into equities and how much into bonds.
“All local government pension schemes are very long term investment vehicles and should take a longer-term perspective that has regard to their liability profile. So if they have a very mature membership and they have a very high level of pensioners compared with contributors, you will want to invest in vehicles that are far more certain in terms of income – so that will push you more towards bonds.” Conversely, where liabilities are more orientated towards the long-term, then funds can be more comfortable in seeking to cover liabilities by the historically reliable higher returns generated by equities.
The Strathclyde pension fund, the largest local government fund, has had £1bn wiped from the value of its assets in recent months, reflecting its large exposure to UK equities. But this has not caused the fund managers to believe their investment strategy is wrong.
“Like any fund, we put a great deal of thought into our position and continually examine our strategy,” says a spokesman for Glasgow City Council, which manages the fund. “However, we don’t believe recent events are likely to prompt a wholesale move out of equities by local authority funds. If cost is your main concern – as it is for us – then equities are the best way to mitigate it.
“However, if you are more concerned about volatility and how things look on your balance sheet – like most corporates – then you probably would want a more bond-based strategy, although it will cost you more over the long run. It possibly feels more comfortable right now but, equally, this wouldn’t be a great time to sell equities and buy bonds. Officials still think a heavily equity based strategy is right for the Strathclyde Pension Fund – and are fairly sure most other local authority schemes will also continue to think that is the case.”
* The investments
Public sector Private sector
UK equities 29.81% 23.74%
Overseas equities 22.83% 13.5%
Private equity 1.84% 0.59%
Hedge funds 0.95% 1.8%
UK gilts 12.35% 17.71%
Corporate bonds 8.94% 12.36%
Property 7.06% 4.5%
Cash 2.19% 2.33%
Source: National Association of Pension Funds, from pension funds replying to survey. Information as at July 2008.
Note: various minority classes of investments excluded, so does not add up to 100%