Expert View: To win at pensions, try the Fischer Black strategy

Once dangerously radical, it now seems only common sense
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The Independent Online

The yield on long-dated, index-linked UK gilts has recently fallen to 1.2 per cent. The 300-year average, according to an analysis by David Miles and Niki Anderson of Morgan Stanley in the Institute for Fiscal Studies' Green Budget, is just over 3 per cent. In the 1970s it was 4.5 per cent and in the 1980s 5 per cent. Real gilt yields are only a quarter of their 1980s level. That is some bubble.

The rise in gilt prices (and consequent fall in yields) reflects a global increase in demand for safe long-dated sources of income. It is not just UK gilts whose yields have been falling, though these yields are lower (and have been low for longer) than yields on comparable long-dated US and French securities.

Does this have anything to do with all those deficits in UK occupational pension schemes? It might. Companies with large pension fund deficits are coming under pressure from their pension fund trustees to put extra money into the schemes. The trustees are supported by the new legal requirements, monitored by the Pensions Regulator, that companies must put in place plans to eliminate their deficits. That means buying securities to put into the scheme.

Do these securities have to be long-dated gilts? Not necessarily, but in practice pensions may be funded more with bonds than with equities in future. The reason is that boards of trustees are becoming focused on the problem of pensions funding, which they want solved once and for all. That means having greater certainty that their pension promises can be met for the future. And that in turn means more bond funding.

However, the gilts bubble means that the certainty associated with bond funding of pensions comes at a very high cost. The argument for accepting the risks attached to equity funding has always been that it is cheaper in the long run. That argument is now stronger than ever. The pensions funding dilemma faced by companies remains acute.

Is there any way out? According to the Green Budget, there is. Some large companies thinking of purchasing gilts to reduce their pension fund deficits may also be large borrowers. For borrowers, low interest rates can only be good news. There is no reason why the Government has to be a monopoly provider of long-dated, fixed-interest securities. Companies also issue bonds. It is true that most corporate bonds are issued over a five- to 10-year horizon, whereas government bond issues can stretch out for 20 or 30 years. But at the very attractive borrowing rates for long-dated securities that are now on offer, large blue-chip companies must surely start to consider borrowing longer term.

As Milse and Anderson put it: "One possible impact of the de-risking of pension fund portfolios might be that issuance of long-term corporate debt rises sharply. Indeed, this is a natural response and one that shareholders should welcome. If a company issues more debt ... but simultaneously buys more debt to hold as a matching asset against its pension liabilities, it has not increased its net debt and its overall gearing has not changed. Indeed, this could create a gain because of the tax deductibility of the interest on the debt it has issued."

I wrote an article for this column in March 2003 explaining the benefits of the strategy. That was 22 years after the Nobel Prize-winning economist Fischer Black first advocated it. It still seemed dangerously radical to most boards then. But in the face of a continuing pensions crisis compounded by a gilts bubble, it seems only common sense.

Buying bonds for the pension fund while issuing bonds in the company means that firm-plus-pension-fund has not changed its capital structure. There is no overall change in risk. The pensions problem is addressed. The high cost of buying gilts is offset by the low cost of the new borrowing. And the icing on the cake is a tax benefit.

Bill Robinson is director of economics at PricewaterhouseCoopers

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