We've shaken off the cult of equity at The Boots Co. PLC. As a strategic move to minimize investment risk, the Boots pension fund sold all of its equities and short-term bonds and moved 100% of its assets into AAA/Aaa sovereign long-dated sterling bonds. The pension scheme - one of the 50 largest U.K. pension funds, with 72,000 members and L2.3 billion in assets - made the move to bonds from equities over a 15-month period, completing it last July. The bonds are a very close match for the maturity and indexation of pension liabilities. They have a weighted average maturity of 30 years; 25% of the bonds are inflation linked.
Matching assets and liabilities has reduced risk for the Boots' shareholders and creditors, who no longer face the possibility of increased corporate cash contributions to make up a pension fund deficit. It also has reduced risk for scheme members, as the value of assets should always be enough to pay all pensions, regardless of any movements in financial markets.
This risk reduction has been recognized by the credit-rating agencies, which are increasingly aware of the impact of a company's pension plan on its overall creditworthiness. By reducing "off balance sheet" risk we can increase "on balance sheet" risk, within the same rating.
The change in strategy also has fixed the Boots' long-term pension contribution - around L50 million per annum in real terms - and significantly reduced investment management costs to L250,000 from about L10 million, as the bonds are held with no trading and automatic reinvestment of net income.
This move has created an earthquake in the U.K. pension fund and investment world and has received huge press coverage (including Pensions & Investments, Nov. 12). Despite some of the comment, the move was not driven by the requirements of the controversial new U.K. accounting standard, FRS 17, which values pension assets and liabilities on a market basis. However, FRS 17 does allow shareholders, creditors and scheme members to see clearly what we have done and to see the risks in equity investment. The FRS 17 surplus was L300 million pre-tax as of Sept. 30. Had we not moved out of equities, the position would have been L350 million worse, giving the Boots scheme a deficit of L50 million.
Equally, the move was not driven by the maturity of the Boots scheme. About half of the scheme members are current employees, so the scheme is not very mature. Many U.K. and U.S. schemes are much more mature.
Although we were lucky to sell equities into a falling equity market and buy bonds in a rising market, we were not trying to outguess the market. The move is strategic, not tactical.
This move by Boots turns pension fund conventional wisdom on its head, both in the United Kingdom and the United States, where final-salary pensions are very similar to those in the U.K. For a generation, the "cult of the equity" appears to have served U.K. and U.S. pension funds well, with an apparently reliable long-term outperformance from world equity markets over the last 20 years (conveniently forgetting Japan). This outperformance of equities over bonds, or equity risk premium, is something that U.K. and U.S. companies seem to have been able to capture through their pension funds.
Conventional wisdom that equities outperform bonds, and that this outperformance reduces pension costs, crucially ignores risk. The equity risk premium is a reward for risk, not a "free lunch." Pension fund risk has been opaque to shareholders, creditors and scheme members because of poor accounting and disclosure requirements. Pension scheme risk will become more apparent in the U.K. over the next three years as FRS 17 is adopted; and shareholders, creditors and pension scheme members will expect it to be properly managed.
Although the U.S. has no equivalent to FRS 17, in a world of international capital markets, one should ask if the same level of scrutiny will be applied to U.S. pensions. If so, U.S. companies, trustees and fund managers should sit up and take notice now.
John Ralfe is head of corporate finance at The Boots Co. PLC, Nottingham, England, and is a member of The Boots Pension Trustee Investment Committee.
