Expert View: Running a pension fund can be a marathon or a sprint

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The Independent Online

We have seen some high-profile corporate takeovers scuppered in recent months by the trustees of defined-benefit occupational pension schemes. They have insisted on greater certainty that pensions will be paid, which means reducing those infamous fund deficits and putting more bonds into the asset mix. But a company's attitude towards its pension deficit, and the equity/bond mix in the scheme, must depend on some parameters that are not often discussed.

We have seen some high-profile corporate takeovers scuppered in recent months by the trustees of defined-benefit occupational pension schemes. They have insisted on greater certainty that pensions will be paid, which means reducing those infamous fund deficits and putting more bonds into the asset mix. But a company's attitude towards its pension deficit, and the equity/bond mix in the scheme, must depend on some parameters that are not often discussed.

Stricter rules now govern the measurement of pension fund deficits in company accounts. The value of assets at today's market prices is compared with the net present value of the pension liabilities, calculated using the returns available from investing in bonds. A deficit says that if the scheme were wound up today, the members would not get all they have been promised.

Many argue, however, that it is not what happens today that matters but whether there is enough in the kitty when the pensioners actually retire. So the urgency of the deficit problem depends on how mature the scheme is - in effect, on how old the workforce is.

This is a question that is surprisingly rarely asked. Yet there are obvious links between the savings strategy for an individual and for a company pension scheme. The standard advice for a young person saving for retirement is to concentrate on equities because they are expected to outperform bonds in the long term. The other side of that outperformance is that equities are a risky investment. But the young investor can take a relaxed attitude to stock market downturns. They are in for the long run and they assume the market will recover.

For the investor close to retirement, by contrast, the risks of equities are very real. If a stock market slump occurs just as you stop working and start to draw on your lifetime savings, your retirement nest egg will be drastically reduced. That is why a standard long-term savings strategy is to switch assets from equities to bonds over the last 10 years or so of your working life. Switching over a long period may smooth out the peaks and troughs in both markets, and avoid the double disaster of converting the whole of an equity portfolio into income at a time when the market is down and interest rates on bonds are also low.

Pension fund trustees, whose job is to make sure that pensions actually get paid, are right to be concerned that there are enough bonds in the portfolio. The sponsoring companies, on the other hand, tend to prefer equities. Their potentially higher returns enable companies to meet their pension commitments with a smaller contribution, thus benefiting shareholders. The brilliant performance of equities during the long bull market reinforced this bias.

In the more difficult conditions that have prevailed since the dot-com bust, the investment case for equities has been weaker. Moreover, under the new accounting standard, the risks of equity investment will be more clearly revealed in corporate balance sheets. Companies that move into bonds run less market risk, and should in due course be rewarded with an improved credit rating and lower cost of capital. This can create opportunities to gear up the company - using the risk capacity freed up by taking risk out of the pension scheme to increase leverage or concentrate earnings.

However, it cannot be assumed that this is the right policy for all. For a company with an "old" workforce, the case for reducing the pension deficit and investing in a higher proportion of bonds may be compelling. It is far from obvious that the same applies to a company with a more youthful workforce.

Bill Robinson is a director of economics at PricewaterhouseCoopers

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