Boots reopens the pensions poser: bonds or shares?

Bear market has fuelled fund managers' concern over the volatility of returns from equities

The decision by Boots, Britain's biggest chemist shop chain, to move its £2.3bn pension fund entirely into bonds has revived for the first time in 50 years the debate over which is better: stocks or shares?

This weekend Boots Pension Scheme trustees wrote to their 72,000 members to tell them that over the last 15 months all the equities in the fund, worth about £1.7bn, had been sold and the money used to buy what they describe as "the highest quality long-dated sterling bonds".

This drew an immediate rebuff from the National Association of Pension Funds (NAPF), which said: "It is, of course, entirely a matter for trustees to decide, in consultation with the employer, on their investment approach. But trustees look to gain from equities outperforming bonds over the long term because pensions are a long-term investment. There may, therefore, be some doubt as to whether Boots' move will set a trend."

The NAPF is implicitly standing on the equities side of the divide, which was first spelled out in 1950 by the late George Ross Goobey, then investment manager of the Imperial Tobacco Pension Fund. Traditionally, shares had yielded higher dividends than bonds, or stocks, because shares were seen as more risky. But Ross Goobey showed that over the long term – which is what matters to pension funds – the return from shares was much higher than from bonds. This became known as the cult of the equity, and was largely responsible for the soaring price of shares in the next 50 years, as pension funds and other big investment funds switched their huge cash flows into equities rather than bonds.

Today, Ross Goobey's son, Alastair, heads Hermes Pensions Management, which is responsible for two of Britain's five-biggest pension funds – British Telecommunications and the Post Office – worth a combined £47.7bn. He said: "I think the Boots decision is really driven by regulation, people living longer, and new accounting rules. I don't think anyone is disputing that equities give a better return than fixed-interest stocks, but it's the volatility of that higher return that is the problem. The critical question for trustees is whether you believe that equities will perform better than bonds."

However, there is a growing gap between companies whose pension schemes pay a "defined benefit" – usually a proportion of the member's final salary before retirement – and the growing number that are based on a "defined contribution", where the benefit is determined purely by how that contribution is invested.

Charles Cowling, of William Mercer, the firm that advised Boots to sell all its shares, explained: "The primary purpose of a pension scheme is to ensure that there are sufficient assets to pay the members' benefits, should the company cease to exist. But there has been a sea change in pensions in recent years. A much higher proportion of a final salary scheme, like Boots', is guaranteed so there is less incentive to take risk. "

A Boots spokesman pointed out that the balance between risk and reward had been tilted by government measures. First, a Minimum Funding Requirement on pension schemes made it more important to meet guaranteed returns rather than go all out for maximum returns. Secondly, Gordon Brown introduced his infamous stealth tax on pension funds. And most recently, the accounting profession has come up with a new rule, FRS17, which requires companies to state their pension liabilities on an annual basis. This makes investing in shares less attractive, as their value can vary widely from year to year even though they may deliver better value over the life of a pension scheme.

"FRS17 means there is no hiding place," the spokesman said, "and we think we are going to see some big deficits when companies start reporting their 2001 results, and they will have to put more money into their pension funds."

But it is hard to predict how many pension schemes are going to be in difficulty. BP had no comment, but an analyst said that its pension scheme, at £12.6bn, was worth less than a tenth of the company, currently valued on the stock market at £130bn. Boots, on the other hand, is worth only £5.6bn – less than three times the size of its pension fund – so any drain on that fund could have a significant impact on the company.

Jeff Denton, head of corporate finance at Marks & Spencer, said that their pension fund was in a different position because the employees did not contribute to it, so had no legal claims on it. However, it is a final salary scheme, paying a massive 45th for every year of service, so its self-imposed targets were high. In the past year, M&S has been transferring a large proportion of its fund from equities to bonds, but on nothing like Boots' scale.

Mike Pomery, a partner of Bacon and Woodrow, the actuarial firm which also advises Boots, said: "If you put the pension fund in equities, it's like driving a car rather fast without knowing what's round the corner. But while Boots may be travelling somewhat slower, the road is straight and clear."