LONDON - U.K. pension funds could have achieved virtually the same level of returns from January 1986 through March 1994 at a much lower level of risk through regular rebalancing of their portfolios, according to a paper by First Quadrant Corp.
The paper, which has been stirring up U.K. pension executives, finds a portfolio with an equity content as low as 50% could have achieved nearly the same return as one that had the average equity allocation during that period. According to The WM Co. figures, the average equity investment for U.K. pension funds (excluding real estate) ranged from 74% in 1986 to 87% by the end of March 1994.
The study is particularly relevant given the current debate over whether many U.K. pension funds should lower their equity allocations because of their growing maturity structures and concerns over proposed minimum solvency rules.
"Minimum solvency and old-fashioned prudence would dictate" a shift from equities, said Bill Goodsall, managing director of First Quadrant's London office and co-author of the paper.
Corporate concerns over having to make immediate cash infusions into their funds when funding dips below 90% - as originally proposed by the government - have been eased as government officials said last month they would alter the proposal to soften its impact.
Faced with heavy lobbying by industry, Secretary of State for Social Security Peter Lilley announced three important changes from the government's white paper on pension reform that was issued last June.
The changes are:
Pension plans with at least 100 million ($156 million) in liabilities will be able to use equities in offsetting their retiree liabilities.
Under the earlier proposal, actuaries could assess the funding level by using equities for younger workers and bonds for older workers and retirees. That might have forced many mature plans to appear underfunded, and could have driven a shift toward bond investments. The relaxation would enable employers to count equities against a maximum of 25% of retiree liabilities.
Employers will receive a full year to get an underfunded plan back up to at least a 90% funding level, up from the proposed 90 days. Also, employers will get five years to reach the 100% funding level, up from three years.
Market values will be averaged over a period of months in calculating the minimum solvency standard for plans, instead of being based on market values on a particular day.
Industry experts praised the relaxation of the proposed rules, although some questioned whether the government had gone far enough.
Tom Ross, vice chairman of the National Association of Pension Funds, London, said: "The government has recognized what we and others have been saying about the need to protect members' security without imposing unnecessary and onerous costs on employers."
Roger Key, a partner with R. Watson & Sons, Reigate, England, added: "It might have reduced by half the relative risk funds would have been running" of falling below the 90% funding level.
Still, the bill is expected to have a bumpy ride. The Labor Party wants participant-nominated trustees to be given half of the seats on boards - instead of a minimum of one-third as proposed. It also is unhappy that at least 10% of plan participants will be needed to petition for changes in existing trustee board arrangements. The party also wants the new pensions regulator, which would be created under the bill, to take a more active role.
In addition, if Mr. Major's government should fall, new elections probably would throw control to the Labor Party, which could result in toughening some of the bill's measures. Even if elections proceed on schedule for 1996, that would come at the time a vote is cast on a pensions act, which would include detailed regulations for the pension bill, noted Richard Malone, European policy director for Sedgwick Noble Lowndes Ltd., Croydon, England.
"There is no guarantee that this (the bill) will become legislation in its present form," Mr. Malone added.
The first reading of the bill in the House of Lords is scheduled for Jan. 24, while the House of Commons is expected to start considering the measure in May.
The minimum solvency rules aside, the First Quadrant study asserts U.K. pension funds have been taking on a great deal of risk for very little extra return. The idea of looking at returns on a risk-adjusted basis is not generally accepted in Britain.
The study examined the period from January 1986 through March 1994, when the average return from stocks was 2.5 percentage points better than from bonds.
During that period, the average fund in the WM All-Funds universe had an annualized return of 14.04%. If the assets had been allowed to drift with the market - that is, if market movements plus income were reinvested in the asset from which it emanated - the annualized return would have been 13.98%.
In comparison, a portfolio rebalanced quarterly to its initial 74% equity allocation would have returned 14.41%, or 37 basis points better than the WM universe. What's more, a portfolio with a 50/50 split between stocks and bonds that was rebalanced would have returned 14.11% - seven basis points better than the WM average fund.
Rebalancing is a disciplined way of forcing managers to sell assets when they are highly valued and buying when they are low. Rebalancing through other methodologies would have not made a great change in returns.
Looking at longer periods of time provides somewhat different results. From 1975 through March 1994, equities greatly outperformed bonds, with an average difference of four percentage points.
Starting with a 70% allocation to stocks, allowing the mix to drift with the market would have beaten rebalancing by 26 basis points a year, at 17.16% vs. 16.9%.
Going back to 1919, the market drift strategy beats rebalancing by 110 basis points a year - at 11.14% vs. 10.04%, based on an initial portfolio evenly split between stocks and bonds. By the end of the period, equity exposure would have risen to 94.7%.
While absolute returns from the drift strategy would have been superior to those from the rebalanced portfolio during the longer time periods, they carry far higher levels of risk. On a risk-adjusted basis, the paper said, there is no time period in which drifting beats rebalancing.
What's more, Mr. Goodsall said stock markets are not going to repeat the average 6% real rate of return provided since 1919.
"If the pattern of future excess returns become more like that of the last 10 years, rebalancing is likely to become a superior strategy," he said.
Mr. Goodsall also found evidence that U.K. funds did not get to an average 87% equity exposure through drift alone. In the 1986 through 1994 period, drift would have raised the equity component to 78%. The additional 9% of assets invested in stocks largely was invested in overseas equities.
That 9% of assets yielded an additional return of only six basis points - a very small return for a considerably greater amount of risk.
Mr. Goodsall said the pressures of maturity and minimum solvency might cause U.K. pension funds to lower their equity exposures and increase bonds. The risk of falling below the 90% solvency test and requiring a cash infusion from the company, while greatly muted by the government's new proposals, still may generate some pressure from the corporate boardroom.
That's "career-shortening stuff," he said.
U.K. investment experts said the study was provocative, but they do not necessarily agree with all of its findings.
For one thing, rebalancing does not solve the minimum solvency problem, said one pension executive, who asked not to be named. "It's a reasonable tool but it's not the answer," he said.
Roger Urwin, head of Watsons Investment Consultancy, said his firm's asset allocation model uses a multiperiod optimization instead of a single period.
On that basis, Watsons consultants expect the premium on equities in the long run to be three percentage points greater than that of bonds.
While rebalancing does make up some of the losses from a higher bond-oriented asset mix, Mr. Urwin said returns start falling off when a fund drops to an 80/20 stocks to bonds mix from 90/10.
Winning over U.K. pension executives won't be easy either.
While some of the largest U.K. pension funds do rebalance their portfolios, the large mass of pension executives are worried about how they perform relative to their peer group.
Jonathan Bayliss, assistant director of Barclays de Zoete Wedd Investment Management Ltd.'s quantitative research department, said pension executives "are not as interested in short-term volatility of absolute returns as they are interested in long-term volatility of real returns."