Boots And Boots

UK pension funds, on average, have about 70% of their non-cash investments in equities. But as everyone knows, share prices go down, as well as up. They did so dramatically in 2001, and the impact on corporate-sponsored retirement savings schemes was severe. Research by WM Consultancy shows that the value of an average UK pension fund fell by 9.6% last year, marking a second consecutive loss-making year.

The inherent volatility risk of equity investment is the main reason behind the decision by Boots Pension Scheme, taken in 2000 and completed in 2001, to divest its equity portfolio entirely. The organisation manages the retirement savings of 72,000 members of the final salary pension plan of Boots Company plc, the chain of UK chemist shops. It has poured all of its investment capital, some £2.3bn, into reliable, predictable fixed income instruments – bonds. Simply stated, bonds are virtually risk free.

John Ralfe, Boots’ head of corporate finance, said the shift out of equities, achieved over about 15 months, served four specific goals: to reduce financial risk; to fix Boots’ contributions to its pension scheme at a constant level; to bring down the costs related to managing an equity portfolio (particularly fees paid to fund managers), and to increase the security of the plan for its beneficiaries.

The risk-reduction effect is crystal clear. Members of the Boots scheme will get their pensions no matter what. Barring a default on their debts by the issuers of the primarily AAA-rated, quasi-government bonds which Boots bought – an event which can be described only as unlikely in the extreme – there is no threat to the ability of the pension fund to pay its obligations in full.

For Boots plc, the shift marks a successful elimination of non-core risk. The company should never be required to top up the pension fund with other corporate cash in order to meet its promised final salary commitments. Running a pension fund is not one of the company’s key competencies, and so, sensibly, it will henceforth face almost no risk from the unavoidable necessity to operate one until the scheme’s membership has expired.

Ironically, the strategy will also allow Boots to save significant amounts, because it will pay a lot less to the people whose core competence is investing pension funds’ money. The Boots fund’s trustees have no intention of switching back into equities at any time in the future, and henceforth will invest future contributions from Boots and its scheme members, and the income from the interest bearing bonds which it holds, into yet more bonds. The reduction in fund management costs could be nearly £10m annually, Boots says.

There is a downside for Boots plc in that there is no chance of creating a surplus in the pension fund, which would allow the company to take a break from making contributions. But the trade-off goes back to the core competency question: Boots is in the business of making money from retailing, not of running pension schemes or investing. The advantage of eliminating a downside risk arising from a non-core activity greatly outweighs the potential windfall from the same source.

The decision also means that beneficiaries will not benefit from a surplus in the pension fund, through a voluntary increased benefit. Such overpayments are common, even though the relevant schemes are designed to pay out a fixed amount based on final salaries, rather than a variable amount based on the investment performance of the fund. Such variances are left for the holders of money purchase pension schemes, which achieve a similar risk limitation function for fund sponsors as the bond strategy has for Boots, but only on a prospective basis. The clock cannot be reversed on the billions of pounds of liability held by UK plc through defined benefit pension schemes.

Effects of FRS 17
Boots’ dramatic action caused something of a ripple in the pension community. Speculation about other pension funds following suit was widespread. Much of the pundits’ commentary focused on Financial Reporting Standard (FRS) 17, a new UK accounting standard governing disclosure of pension funds’ assets and liabilities, and due for full implementation in 2003. Ralfe insists that FRS 17 was not a factor in Boots’ move out of equities, but it could well be a driver that tempts other companies to switch more of their assets into bonds, bolstering a trend that has been under way for two or three years.

The new accounting standard governs the way UK companies disclose pension funds’ gains and losses, and is significant in relation to equity and bond holdings, because of a major way in which it differs from the status quo. Under FRS 17, pension funds’ assets and liabilities will be valued using a discount rate based on the return available on double-A rated corporate bonds at the balance sheet date, rather than according to actuarial estimates. Fluctuations will have to be shown immediately, rather than over time.

“The difference between the value of the assets and the value of the liabilities is likely to be very volatile using this method, especially for those schemes with significant levels of equity investment,” says a spokesman for Barnett Waddingham, the UK actuarial consulting firm. “Even in the US, where the corporate bond market is much more developed, there is considerable variation in the level of the discount rate used. It will be important to remember that just a quarter of a percent change in the discount rate could have a significant effect on the value of the liabilities, and hence the reported pension costs.

One attraction of bonds is the ability to match pension fund liabilities accurately to long-dated bond values, which tend to grow at about the same rate. Indeed, the Minimum Funding Requirement, the UK rules governing asset allocation in UK pension funds, have driven many funds into UK government bonds, called gilts. The MFR sets out relatively simple tests to ensure (in theory, at least) that pension funds accumulate assets which are sufficient and most likely to match their future liabilities, even if the employer becomes insolvent. Gilts are the MFR’s standard benchmark for calculating near-term liabilities, and, clearly, gilt assets are guaranteed to change in value at exactly the same rate as liabilities calculated against the value of gilts.

Yet the MFR is set to go the way of the dodo. The high-profile Myners Report recommended its abolition, and the government has said it will follow the advice. The response in the gilts market was swift. The day the Chancellor announced his intentions for the MFR the yield on 30-year gilts was boosted by five basis points to 4.47%, as the fixed-income market anticipated a loosening of the demand squeeze. A second five basis-point jump followed.

The scrapping of the MFR and FRS 17 together give generally risk-averse pension fund trustees more leeway to invest in non-government bonds, including corporate issues and the quasi-government bonds (from institutions such as the World Bank) which account for the bulk of Boots’ revamped portfolio. Unfortunately, however, long bonds that match pension funds’ liabilities are in increasingly short supply. It is not far from the truth to say that Boots has bought most of them.

The concept of investing in bonds the Boots way requires holding the instruments to maturity. That means there are few secondary sellers. Long bonds require issuers to pay high interest rates, so some major issuers have eschewed them – the US Treasury, for example, has halted plans to issue additional 30-year T-bills. In the UK, demand for long bonds brought about by fewer issues was so fierce that it caused the UK bond yield curve to invert for a time, a strange side effect of government policies on pension funding and borrowing.

The low interest rate environment and an economic slump could change the balance as governments seek to invest more, and are willing to pay higher interest to secure long-term borrowing. Time will tell,

Corporate bonds may come to fill the void, with issues increasing with demand. But there is an inherent riskiness in corporate bonds that the kind of paper Boots bought does not carry. Ten years ago companies such as Marconi, Xerox, and Polaroid might all have looked like safe bets for a 30-year loan. A company’s fortunes can change.

So far, however, there has been no stampede from equities into bonds. Rather, the slow change in the ratio of equities to bonds continues, although it remains a long way from the 50/50 split of the early 1960s. Concerns that a wholesale withdrawal of pension funds’ billions from the stock market would cause serious downward price pressure, have not materialised. If anything, the opposite may happen: failure to switch to bonds could cause price crises if FRS 17 inflicts volatility damage on some companies that have too much in equities.

In the end, however, money purchase pension schemes look set to eclipse defined benefit plans. Already many of the latter are closed to new members. With money purchase, investment performance risk lies with the beneficiary, whose plan, in essence, works on the principle of you get what you pay for. If you are Boots, you have bought certainty.

Adrian Leonard is insurance market correspondent, StrategicRISK

CODE OF CONDUCT CRITICISED
Although the UK Association of Consulting Actuaries (ACA) has welcomed the Government’s response to the Myners review, it is concerned that, in the wake of an announcement of a simplification review, further complexities are proposed. Its main concern is the extra time and cost involved in full compliance with the Code of Conduct.

“This is not an opportune time for pension schemes to shoulder extra administrative requirements. The ACA believes that the Government has under-estimated the extent to which trustees comply with most of this code at the present time without necessarily documenting each point and communicating these matters to members. Thus, full compliance may lead to less change in actual investment decisions than the Government expect,” says Colin Richardson, ACA investment committee chairman.

The ACA also has reservations about some of the content of the Code of Conduct for investment decision-making. “In particular, the extra disclosure requirements will have little value for scheme members. There is a risk that more information may lead to more confusion rather than to more understanding,” says Richardson.

The ACA believes that the provision that mandates that fund managers should not be terminated before the expiry of an evaluation timescale, for under-performance alone, remains inflexible and one-sided. It says that it cannot be right to fetter trustees’ discretion to change fund managers. They tend to remove managers only after due consideration and as a last resort in any event.

Although calling the Code voluntary, the Government is effectively making it compulsory by installing an assessment that is expecting an increase towards 100% in the proportion of funds complying with each point. The timetable has also been tightened by making the assessments in March 2003.

An ACA November 2001 survey of pension trends in smaller firms highlighted evidence of continued low pension contributions into money purchase schemes, which will spell misery for many pensioners in the years ahead. The survey results – based on responses from 418 firms employing 250 or fewer people – showed that combined employer and employee contributions into money purchase schemes average under 9% of earnings, some 5-7% below those into final salary schemes.

The ACA said that this ‘contribution gap’ points to many pensions falling far short of expectations in the years ahead. The problem is likely to be exacerbated by a host of other factors including: