It's been a year since The Boots Co. shocked the U.K. financial world by announcing its L2.3billion ($3.5 billion) pension fund - one of the U.K.'s 50 largest, with 72,000 members - had sold all of its equities and moved its assets into long-dated AAA/Aaa sterling bonds.
Rejecting the holding of any equities challenges head-on the accepted U.K. and U.S. wisdom of the last 30 years, that company pension funds should hold most of their assets in equities.
This rejection of the cult of the equity was based, unashamedly, on financial economics. The conclusion that pension assets and liabilities should be matched, with U.K. and U.S. pension funds holding bonds not equities, is standard corporate finance textbook stuff, going back to the late Fischer Black in 1980.
The move to bonds reduced risk for Boots' shareholders and bondholders because the value of pension assets and liabilities now move in tandem, reducing the risk of a future pension deficit, needing higher company contributions.
Pension members also have less risk, as they no are longer reliant on the performance of equities for their pensions. Legal protection for members is weaker in the United Kingdom than in the United States, and there is no equivalent to the Pension Benefit Guaranty Corp. - there are many people in the United Kingdom who have lost their jobs and some, or all, of their pension when their employer goes bust.
By selling equities during 2000 and 2001, Boots locked in a surplus, which has fixed future contributions at their current level in real terms. The move also reduced fees, and costs were slashed to L300,000 a year from L10 million.
U.K. pensions are inflation linked up to 5% per annum. Over the last year we have been able to increase the inflation-linked assets to 50 percentage points of allocation through interest rate swaps, with a range of maturities extending from 2016 to 2030, giving a better match for the pension guarantees. The Boots Co. itself has completed a L300 million share buyback, made possible by moving to matching bonds. Reducing risk "off balance sheet" in the pension fund has allowed Boots to increase risk "on balance sheet." Because the credit-rating agencies recognized the reduction of risk in the pension fund, this share buyback was possible without weakening the current credit rating.
During 2002 the value of pension assets has increased and continues to be enough to pay all accrued benefits. Had we still been in equities, there would be a major shortfall.
Boots' move has reminded people of a self-evident truth that has been forgotten over recent years - the pension fund's job is to pay pensions. Asset allocation should be driven by the nature and risk of the pension liabilities: the maturity of the fund, the size of the fund vs. the size of the sponsoring company, the creditworthiness of the sponsor, and the level of surplus or deficit in the fund.
The world also has been brutally reminded that equities are not a one-way bet. When equity markets were rising inexorably it was easy to ignore those people challenging the cult of the equity. World equity markets at current levels concentrate minds wonderfully; they're more than 30% off their peak. From today's current absolute levels the equity market could go up or it could go down, just like flipping the coin. Meanwhile, pension liabilities have increased substantially over five years, as long-term interest rates have fallen.
All U.K. companies have reported under the first stage of the new accounting standard, Financial Reporting Standard 17, over the last year, showing many of them with deficits. The aggregate shortfall in U.K. pension funds has been estimated at L100 billion. Shareholders and the credit rating agencies are starting to ask questions.
The U.K. pensions world is in a period of major transition. Several pension funds have made a 10 or 20 percentage-point shift in asset allocation to bonds from equities and are well below the average of 75% allocation to equities. Rumor suggests others still are in the transition process.
Even if U.K. pension funds seek only to match their pensioners and deferred pensioners with long dated bonds, the amounts involved and the implications are profound.
The challenge to the cult of the equity is starting to gain ground in the United States. Any move by U.S. pension funds from equities to matching bonds would lead to structural change on a global scale, dwarfing anything we have seen or are likely to see this side of the pond.
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.