Expert View: Pension shortfalls need Black magic

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The Independent Online

What exactly are these pension fund deficits that have been in the news recently, and what can be done about them?

What exactly are these pension fund deficits that have been in the news recently, and what can be done about them?

From a shareholder perspec- tive, the deficits are a future profit and loss problem – the difference between the payments promised by companies to employees in their pension fund, and the income from the assets in the fund. Since the promises won't be redeemed until the employees retire, a proper assessment requires careful modelling of the obligations of the fund, and its potential future income.

What we get instead is a headline snapshot of assets and liabilities. The liabilities are sensitive to the discount rate, itself a function of interest rates, but do not otherwise vary much from one year to the next. The assets, though, are immediately affected by current market prices. So after a three-year bear market it is not surprising that the assets in many pension funds are worth a lot less than the liabilities.

These deficits suggest that the company may need to put in more money to meet its obligations. And the bigger the fund relative to the company, the greater the risk to shareholders and bondholders. This is why credit agencies are taking an interest: Standard & Poor's downgrade of BAE Systems last week was linked to pension worries.

Pity the poor finance director. Analysts are now very aware of these pension risks, and if the markets continue to slide, the deficits will grow. In these circumstances, pension fund trustees who do nothing could be criticised. But the FD who persuades them to address the problem by switching into bonds will be pilloried if equities revive.

There is a lot to be said for matching fund liabilities, which are guaranteed bond-like obligations, with assets having a similar risk profile. That case has strengthened as the benefits have become less discretionary. But bonds have been out of fashion ever since George Ross Goobey persuaded the industry over 40 years ago that equities were a better way of funding pensions. He was quite right – at the time. Anyone who invested in bonds in the 1960s or 1970s saw capital values dramatically eroded as interest rates went to double digits. And if they held to maturity, they were repaid in inflation-ravaged pounds worth a fraction of their real initial value.

But the world has moved on. An independent Bank of England has a good track record in hitting its 2.5 per cent inflation target. Pension funds which remain suspicious of conventional bonds can buy index-linked gilts, providing a safer but equally inflation-proof alternative to equities.

So a switch into bonds, if only partial, is a defensible strategy. But it is still a big step to take because it would lock in a deficit and rule out rescue by rising equity markets.

That is why many FDs are looking at the "Black strategy". Fischer Black, an eminent economist, wrote an article in 1981 suggesting that firms would do well to move the equities in their pension funds into bonds, while simultaneously issuing bonds and buying equity inside the company. His argument was that this would produce tax savings (just as a debt-financed share buyback does).

His scheme, ignored for two decades, looks especially interesting today. The first operation takes the risk out of the pension fund. The second provides a hedge, ensuring that the firm-plus-pension- fund has not changed its capital structure. The FD who makes the double switch is protected from criticism. If shares take off, the company has bought cheaply. If bonds bomb, it has got its debt away at a good price.

It seems neat, particularly as the tax savings should more than pay for any implementation costs. Is it an idea whose time has come?