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Emerald Group Publishing Limited
Copyright © 2004, Emerald Group Publishing Limited
A new financial strategy: run risks in the company not the pension fund
Bill RobinsonHead UK Business Economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former Special Adviser to the Chancellor of the Exchequer.
The conventional wisdom is to hold equities in the pension fund
For the past quarter century at least it has been the conventional wisdom that pension obligations were best matched by equities. Company pension funds hold a high proportion of their assets in equities because they believe equities deliver higher returns than bonds over the long term. The out-performance (the equity risk premium) they expect is around 3 percent per annum. Putting £100 into equities rather than bonds is thus believed to deliver an extra £3 of income to the pension fund. This belief has been underpinned by the accounting conventions for pensions, which have allowed the pension funds to score this extra income, regardless of what actually happens. This reduces the required company contributions to the pension scheme, which in turn means that the P&L looks better.
Yet holding equities in the pension fund is risky …
As stated above, moving pension fund assets from bonds into equities looks like a costless way of boosting profits. But there is a cost. We can all agree that equities should deliver a higher long-term return than bonds. But we also know they are riskier. You get the additional expected return as a reward for running the extra risk. Holding equities in the pension fund uses up some of your capacity to bear risk, and in this sense competes with risky projects that you might wish to take on in the business.
Even though the risk used to be concealed by the SSAP24 accounting convention
Yet investing in equities in the pension fund is not viewed in this way by the majority of company boards. This is because the risks attached to equity investments held in the pension fund have been all but invisible. It is obvious at one level that funding pension schemes with equities is risky. After all, if they under-perform, the company will have to make good the shortfall. But the fact is that for the quarter century (at least) leading up to the dotcom crash of 2000, equities hardly ever fell. And even if they did, then under the old SSAP24 accounting rules the risk was concealed.
How was risk concealed? By, first, adopting the convention that the present value of future pension liabilities should be calculated using a discount rate which was a weighted average of the equity and bond rate, where the weights reflected the respective proportions of equities and bonds in the pension fund. And, second, by assuming that if the stock market fell, it would rise faster in future. As a result of these assumptions, a stock market decline, which obviously reduced the value of pension assets, would also reduce the value of pension fund liabilities (because they would then be calculated using a higher rate of interest). Pension fund deficits were thus relatively insensitive to stock market gyrations. So equity funding for pensions did not look risky.
The risk has now been revealed – by the fall in equity markets …
The world has now changed in two important respects, but pension funding policy has not yet adjusted. The first (and most important) change was the fall in the equity market still, after its current rally, well down from the 2000 peak. Equities are risky. They can fall. The proof is they just did, and a lot of pension funds are now nursing large deficits.
… and by the adoption of new accounting rules
The second change is the adoption of new accounting rules for pensions under IFRS, which become mandatory next year. Under the old SSAP24 rules the impact on pension fund deficits of a stock market collapse was mitigated by a fall in liabilities, as explained above. Under the new rules all pension liabilities are calculated using a commercial bond rate. Two things follow. The deficits look larger because the discount rate is lower. And the pension liabilities are now quite invariant to stock market performance. So if the equity market falls, and a fund is heavily invested in equities, there is no compensating fall in pension fund liabilities. The bottom line is that, for a pension fund heavily invested in equities, pension fund deficits are not just much larger on the new accounting standard. They are also much more volatile.
That is why, under the new accounting standards, the risks of holding equities in the pension fund will be starkly revealed. To the extent that analysts take pension fund deficits (calculated on the new basis) into account in arriving at market valuations, this should also make the share price more volatile. This in turn increases the company's beta, pushes up its cost of capital, and reduces its value.
So companies may now consider reducing their equity exposure in the pension fund
If the bond-equity choice in the pension fund has been biased in the past by the concealment of equity risk, then it is a reasonable bet that increasing numbers of companies will be inclined, now that the risk is revealed, to reconsider the bond-equity split in their pension fund portfolio. Suppose they consider bucking what used to be the conventional wisdom and move from equities to bonds in the pension fund.
Because under IFRS this will not make the pension fund deficit look any worse
Under the old rules such a move would have been ruled out on the grounds that it would at a stroke increase the pension fund deficit. Because, remember, it would under SSAP24 have reduced the discount rate used to assess liabilities, thereby making liabilities look larger. Under the new rules the liabilities are already assessed at the bond rate whatever the bond/equity mix. The bad news is that they look larger than before. The good news is that they won't get any bigger as a result of switching to bonds. So a policy which was previously unthinkable can now at least be considered.
… and it will free up some risk capacity
Next consider the effect on risk. Moving from equities to bonds reduces the risk in the pension fund. It thereby enables the company to run an equivalent amount of risk in the core business without worsening the credit rating. So let us suppose the company issues some debt and uses the proceeds to fund a capital project. Consider the net effect of this double transaction. The board has decided:
to issue debt in the company and buy bonds in the pension scheme; and
to dispose of an equity stake held in the pension fund and acquire a new equity stake in a project run by the company.
… to devote to the core business …
One advantage of this exchange is that the company is now holding an equity stake in a project in its core business. In other words it is taking on the kind of risk that the directors are paid to manage. It has in return given up the risk of holding other companies' equities. Most boards of directors would regard that as a positive move.
… by means of a double transaction which also secures a tax advantage
The other advantage is a tax advantage. Bonds held in the pension fund pay interest on which no tax is charged. But the interest on the bonds issued by the company to finance the new capital project is tax deductible. This tax relief is a pure bonus, which for a reputable company able to borrow at fine margins will far outweigh any difference between its own borrowing rate and the interest rate on the corporate bonds it has bought to hold in the pension fund.
The only drawback is a short term hit to the P&L
So why isn't every company with a bankable investment project rushing to finance it in this way? The answer is that the accounting treatment militates against it for any company that is not prepared to take the long view. From a narrow accounting perspective it still remains true under the new rules, as under SSAP24, that switching from equities to bonds in the pension scheme results in lower expected investment income in the pension fund, implying a higher contribution from the company and hence lower profits. The equal and opposite gain in the company, as money is borrowed at the debt rate of interest and invested to make an equity return, is not immediately apparent in the accounts. There are few investments which reliably deliver the equity market risk premium in the first year.
For those prepared to take the long view there are large gains in prospect
For any company prepared to accept the short term hit on the P&L in return for the long term gain (and prepared to explain these complexities to the City) the arrival of the new mandatory standards for pensions accounting represents a massive opportunity to secure cheap funding for long term expansion. So far few companies have understood the opportunity and fewer still have acted to exploit it.