FT REPORT – FT FUND MANAGEMENT: April 23rd 2007
The pensions prophets 10 years on
By Barry Riley
The so-called “EMS” paper presented to the Institute of Actuaries in London 10 years ago, on April 28 1997, blew the gaffe on a whole era of actuarial practice in relation to corporate pension funds in the UK. A decade later it can clearly be seen as truly revolutionary.
The paper, The Financial Theory of Defined Benefit Pension Schemes, was put together by experts with the eponymous three letters starting their names: one, Jon Exley, was a practising pension consultant; Shyam Mehta was at that time a corporate financier at Merrill Lynch; and the third was a more general actuary, Andrew Smith.
Using rigorous analysis they prised open the confined world of pensions actuaries. But the about-to-be-appointed chancellor of the exchequer, Gordon Brown, was plotting to tax dividends received by pension funds. Just over two months later he pounced.
In the course of the long equity bull market (which at that stage had been running for 15 years) actuarial valuation methodology, which was based primarily on equity income growth, had generated enormous “surpluses”.
Half of corporate sponsors had either reduced the level of contributions into their schemes or had cut them out altogether because adding to surpluses was regarded by the Inland Revenue as tax avoidance. Pension schemes had carelessly disobeyed the unwritten law of pension funding: never declare a surplus. But even though the bull market in equities was still in full swing in 1997, the EMS trio demolished the British actuaries’ obsession with the merits of the equity asset class as a painless way of funding pensions. They showed there was no reliable historical correlation between dividends and employee earnings – the latter being the key determinant of final salary-linked liabilities.
Investment strategy, they said, should ideally be based on index-linked and fixed coupon British government securities, with only a small role for equities. And a scheme’s investments should be marked to market, not valued according to an artificial long-term formula.
At the time all this defied the consensus. Behavioural dynamics are powerful. Equities accounted for about 75 per cent of pension fund portfolios, and pension consultants and the asset management industry were entrenched in their views.
It took several years for the old system to begin to unravel. The equity boom rolled on for a while (but simultaneously bond yields tumbled with ominous, but ill-understood, implications for pension scheme solvency). In the end, there was a spectacular flip of the consensus.
The well-known first mover was the Boots scheme, with a 100 per cent switch to bonds in 2001, influenced by John Ralfe, then the company’s in-house corporate finance adviser. He points out that like the EMS authors he was focusing on the combined interests of the pension scheme and its sponsor, rather than on the scheme in isolation. The current fashion for liability-driven solutions is rather different, being fund-centred, although it also leads from equities to bonds. At any rate, last year UK pension funds and life companies were net sellers of £29bn of UK equities and net buyers of more than £70bn of fixed income securities.
Actuarial historians will no doubt debate the reasons for the profession’s errors. They may conclude that it was unfortunate that pension actuaries sought to protect defined benefit schemes by hiding the true costs and risks from sponsors and trustees.
Ironically, the three authors claimed in their paper that it was their ambition to rescue UK defined benefit pension schemes from the consequences of sponsoring companies becoming unexpectedly aware of their true risks – including the extra regulatory burdens then recently introduced under the Pensions Act 1995. Unfortunately, this aim failed. Within a few years of 1997 most defined benefit schemes had been shuttered to new members. Today more and more are being closed to the accrual of benefits by existing members and specialist buy-out companies are clustering to offer sponsors a final exit.
Could more defined benefit schemes have been saved? Last week Jon Exley, now at Barclays Capital, said that sponsors and trustees had not moved fast enough.
I concluded my column 10 years ago with the comment that if an incoming Labour government were to attack dividends the actuarial profession would find itself in urgent need of new valuation methodology.
But what has actually transpired has been even worse for the profession: the new techniques have subsequently been imposed from the outside by accountants and regulators.