LONDON - Twin changes affecting U.K. pension funds could drive them into greatly reduced equity positions.
Chancellor of the Exchequer Gordon Brown's immediate abolition of tax credits for dividends paid to U.K. pension funds announced in his July 2 budget may impair returns and reduce funding levels.
Proposed new international accounting standards would value pension funds at market, as opposed to the U.K.'s traditional actuarial approach that smooths out volatility. The International Accounting Standards Committee meets this week in Beijing to consider a new standard.
Combined, the effect of the twin changes could spur a significant shift out of equities. The (British pounds) 600 billion U.K. pension fund market has nearly 80% of its assets invested in stocks, of which 53% is allocated to U.K. equities.
The tax change could prompt funds to shift five to 10 percentage points of their assets "at a maximum" out of equities, predicted Peter Ludvik, head of asset allocation and a partner with Watson Wyatt Worldwide in Reigate.
Previously, tax-exempt investors could reclaim 20% of the advanced corporation tax paid by British companies on share dividends. With that now swept away, U.K. equities don't look so attractive and consultants are predicting an immediate impact on pension funds' total returns.
"We are talking about pension funds now subject to an annual loss of (British pounds) 2 billion a year," observed Alan Fishman, chief actuary at Sedgwick Noble Lowndes in London.
Such a loss, strategists warn, could in turn have a domino effect on asset allocations.
"Today's asset-liability study would likely result in a lower equity allocation than yesterday's," said Michael Peskin, a principal within the global pensions group of Morgan Stanley & Co., New York.
Still, equity investing remains the cultural norm in the United Kingdom and actuaries themselves are cautious about advocating an immediate shift into bonds.
"We wouldn't recommend anyone to change their asset allocation yet," said Mr. Ludvik at Watson Wyatt. "We'd have to do a lot more research and what-if scenarios first."
Nevertheless, Mr. Brown's abolition of tax credits is the latest in a long line of changes that ultimately favor greater bond exposure. The 1995 Pensions Act coupled with the minimum funding requirement have forced U.K. pension funds to scrutinize their funding levels and, in some cases, to increase their exposure to bonds.
Proposed changes to international accounting rules might introduce further pressure for them to alter their asset allocations.
Last fall, the IASC published Exposure Draft 54, which proposed pension fund assets should be valued at market value in line with current practice in the United States.
At this week's meeting in Beijing, the IASC is likely to approve the draft and recommend the adoption of a new standard this November.
But many groups representing U.K. accountants and actuaries are fiercely resisting the change, preferring to stick with the traditional method of discounting future income, which smooths over volatility.
"To move to the American approach will introduce a lot of volatility in funding," predicted Matthew Demwell, an official with the Association of Consulting Actuaries in London.
Pension funds find volatility unsettling, and it increases the likelihood of them switching to less risky assets such as bonds.
The proposed accounting changes, however, are unlikely to have any impact on U.K. subsidiaries of U.S. companies because they already comply with U.S. generally accepted accounting principles, which require mark-to-market valuations.
