Serious Money: Switch from equities to bonds leaves companies with a 3 per cent annual shortfall, writes Chris Johns

Boots is well-known for its chain of pharmacy stores throughout Britain and Ireland, but is also famous throughout the fund management industry for its decision a few years ago to switch all of its pension fund investments into bonds.

At the time, along with many other people, I criticised the decision on the grounds that it would end up costing shareholders a lot of money. The finance director responsible for the decision phoned me up and politely explained why my views were based on an incorrect premise. He was also at pains to point out that the move into bonds - out of equities - was not a punt on the markets, although on this point I found him less than convincing.

At the time, equities were falling and were destined for a three-year bear market that made his call on stocks look like an exquisite piece of market timing. If he wasn't making a negative bet on equities, he nevertheless must take credit for an inspired decision that - as it turned out - saved the company and its shareholders a lot of money. But that still doesn't mean that the switch into bonds was right. Only time - measured in decades - will determine the outcome.

The incorrect premise that I was accused of making was that I assumed shareholders would want to pay the least amount of money possible into the pension fund. Not true, I was told. Boots had decided that the risk of equities underperforming bonds for prolonged periods of time was so great that they were prepared to live with paying more into the fund - over its full life - so that they could sleep at night.

While they fully accepted that equities will do better than bonds over very long time-periods, they were scared of the short-run volatility that equities deliver. In particular, they were apprehensive about short-term funding shortfalls that can arise during savage equity bear markets.

All of this can seem a touch paradoxical: if equities are likely to outperform bonds over the long haul, why would anyone prefer fixed-interest securities? The answer lies with what equities can do to you over the shorter term and whether or not fund trustees - and the people responsible for paying into the fund - can live with volatility.

In a given year when, say, equities drop by a considerable amount, a solvent pension fund can quickly end up looking like one that cannot meet its future liabilities. In such circumstances, it might well be right to argue that equities remain the best long-term bet - but it rarely feels that way when markets have just dropped 30 per cent.

In the spring of last year, many trustees would have been in a state of despair and would have been incredulous if anyone had suggested that global stocks were about to rise by between 20 to 40 per cent which, of course, is what they proceeded to do. But that is what volatility looks like.

Boots assumed that stocks will return around 3 per cent a year more than bonds over the life of their pension fund. Volatility is such that this excess return is never delivered in a smooth way - some years are very good, others are horrible. But history teaches us that patience rewards the equity investor more than the bond-holder. In fact, history teaches us that equities return around 4 per cent more than bonds. There is an argument that says this number will be lower in the future - an argument probably used by Boots. But, whatever the number, we can calculate with precision the cost to the company of moving all of its pension fund into fixed income.

By buying bonds with a known return, we can calculate how much money is available for paying pensioners. For Boots, that amount of money is reduced by the extra 3 per cent a year that it would have obtained by investing in equities. That difference is made up by extra company contributions into the fund. The company and its trustees have absolute certainty - there will never be a funding shock - but it comes at a price.

And Boots was quite clear: that was a price they were willing to pay in order to avoid the shock in any given year - or years - of equities doing very badly.

Boots was lucky in that it was able to buy bonds that were yielding a lot more than they are now, and it also allowed itself to buy securities not issued by governments. Bonds always carry a default risk, particularly when the issuer is not a sovereign government. But Boots was able to match up known and certain returns from fixed-interest securities with the known liabilities of future pension commitments. The implied cost - giving up higher returns from equities - was acknowledged up front but Boots was willing to pay it.

Few of us are in so lucky a position. A similar calculation for other pension funds, or individuals saving for a pension, would throw up some terrifying funding consequences.

We would have to pay in much more than we are likely to be able to find in current salaries. But many pension funds do use bonds as a way of smoothing volatility: a typical fund uses the 80/20 rule that puts 80 per cent of assets in to equities and the rest in to fixed income. Lots of mumbo jumbo about asset-liability matching accompanies this asset allocation but there is usually a Boots-style desire to lower overall volatility behind the decision.

For anyone involved in pension planning, bonds perform a useful function. The nearer you are to retirement, the more bonds you should have.

Mr Charlie McCreevy's National Retirement Fund spent a lot of money on advice over the appropriate equity/bond split, and few cynics were surprised when the 80/20 rule emerged. There may well be a case for arguing that a pension fund with as young an age-profile as represented by the Irish population should have even more equities. Conversely, mis-selling scandals have been known to occur when people nearing retirement have been sold equity-based funds.

Would now be a good time to buy bonds? I'll leave that to another article.