The swing against equities may be going too far, write Brian O'Loughlin and Frank O'Brien

Recently bankruptcy-threatened US Airways said it intends to terminate its remaining defined-benefit pension plans and will not make $110 million (€89 million) in pension payments that are currently due.

In the UK members of car parts firm Turner & Newall's pension scheme could lose up to 70 per cent of their pensions if the scheme is wound up. It emerged that the scheme had an £875 million (€1.27 billion) deficit when it was announced that the administrators of the firm's American parent, Federal-Mogul were freezing the scheme.

Federal-Mogul has been in Chapter 11 voluntary administration since 2001, and the pension scheme's trustees are arguing that the firm needs to make extra contributions of £29 million a year for the next eight years on top of existing payments to wipe out the deficit.

For workers in Irish companies these developments are far away and may seem irrelevant. Unfortunately, they are all too relevant as the pensions industry, corporate executives and policy-makers wake up to the risks inherent in company pension schemes.

By the late 1990s an air of complacency pervaded the entire issue. The long equity bull market meant that most pension schemes seemed to be properly funded. In other words the market value of the schemes' assets usually matched or exceeded the capital value of the schemes' liabilities.

Furthermore, the trust structure ensured that schemes' assets resided in a legal structure separate from the sponsoring companies.

The worst equity bear market since the crash of 1973/74 rudely shattered this air of complacency. Driven by a general air of euphoria that pervaded investment professionals and pension consultants, pension trustees wholeheartedly embraced the "cult of the equity". Throughout the 1980s and 1990s the proportion of pension fund assets allocated to equities rose relentlessly.

For example, in the late 1980s Irish pension funds held approximately 50 per cent of assets in equities, but this had risen to 75 per cent at the market peak in 2000. High equity returns combined with high exposure to equity markets seemed to be a win-win formula. The high returns earned ensured that scheme assets grew fast enough to meet growing liabilities associated with rising salaries, and at the same time companies could hold their funding costs to a minimum.

The precipitous collapse in share values in the two years following the spring 2000 market peak created a gaping hole in the balance sheet arithmetic of pension funds.

The accompanying illustration for a hypothetical company called Blue Skies Ltd typifies how the balance sheet of many pension schemes would have moved over this period.

At their board meeting in early 2000 the directors would probably have quickly passed over the report from the pension trustees showing that the fund had a surplus of €10 million. After all, surpluses had been the norm since the fund was set up in the early 1980s.

Three years later and the picture had changed dramatically for the worse. One can only imagine a very tense board meeting in early 2004 as a very irritable chief executive reviewed the trustees' report showing that a surplus of €10 million had now become a deficit of €20 million. The equity bear market had knocked €15 million off the market value of the scheme's supposedly blue-chip equity portfolio.

As if that wasn't bad enough the actuarial report showed that the capital value of the scheme's liabilities had also increased by €15 million over the same period. The actuaries calculate this figure by estimating the future cost of pensions on a year-by-year basis and they then use an interest rate to discount all of these future payments back to today's present value. If this discount rate goes down then the present value or capital value of the liabilities goes up.

Usually the actuaries use a reference rate based on the yield on long-term government bonds. Over the period in question yields declined sharply. For example the yield on 10-year Irish government bonds fell by approximately one percentage point meaning that the actuaries had to cut the discount rate used to calculate the capital value of liabilities by a similar amount.

New demographic data showing a rise in life expectancy would also have had an impact. For Blue Skies the end result was a rise of €15 million in the present value of its future pension liabilities.

Calling the meeting to a close a dejected chief executive may have tried to wrap up the meeting on a brighter note. Pension funds are very long-term entities and the scheme would have 20 or 30 years to sort out the funding shortfall.

Unfortunately the chief financial officer would have had to interject with some very bad news about something called FRS17. This new accounting standard means that the deficit of €30 million would have to be recognised in the company's balance at end December 2003. On this news it is quite probable that the meeting would have dragged on for several more hours.

In the real world the combined impact of the equity bear market and change in accounting standards has led to a seismic shift in how corporate pension funds are viewed. Up to recently the corporate pension fund tended to be viewed as totally separate to the company. In reality this was always a mistaken view as under defined-benefit schemes it is the company that underwrites the promise to pay pensions. The liability clearly ultimately resides with the company.

The pension scheme is merely a mechanism to set aside money today to meet these future liabilities. If there is a shortfall in the value of the pension scheme it is the company that has to cough up the extra funds.

Should employees be concerned about this state of affairs? The answer is a resounding yes. If Blue Skies is a strong company, then its balance sheet will cope with the new FRS17 accounting treatment and more importantly the company will be able to meet the costs of its pension promises.

However, its board will also try to reduce the funding gap by seeking to reduce the future cost of its pension promises. If this can be achieved then the capital value today of these liabilities will fall.

Measures that may be taken include:

n Increasing retirement age.

n Increasing the rate at which employees contribute to the pension scheme.

n Reducing or eliminating the indexation of pensions in payment to consumer prices.

n Closing the scheme to new entrants.

Clearly all of these changes are geared to save the company money and will increase the costs to members or reduce the value of benefits. However, if the company is in a weak financial position the impact on ordinary members of a pension deficit could be far worse as evidenced by several high-profile cases abroad such as the Turner & Newall scenario mentioned earlier.

The current focus on pension fund liabilities is of course primarily a function of the poor investment returns of recent years. Trustees and their advisers have a heightened awareness of the most fundamental of investment realities: higher returns are associated with higher risks. Throughout the 1980s and 1990s the focus was on achieving ever-higher returns. Now the focus has shifted 180 degrees and is on the risks associated with investing in risky long-term assets such as equities.

In our view the swing in the pendulum is in danger of going too far. Today's obsession with risk is creating an environment whereby trustees are being advised to increase allocations to lower-risk assets such as government bonds, and to reduce allocations to high-risk assets such as equities. This may well be the correct strategy in situations where the average age of the workforce is high and/or where the sponsoring company is in a very weak financial position.

However, for financially strong and growing companies such a shift is wholly inappropriate. Our analysis is based on the view that equities will continue to be the long-term asset that delivers the highest returns. True, in somemarkets over some time-periods, other assets will do better, the Irish property market over the last 10 years being a very familiar such episode, with a return of 19 per cent per annum compared to 13 per cent per annum from Irish equities. Nevertheless, projecting forward over the next 10, 20 and even 30 years the odds strongly support the view that equities will outperform other asset categories.

There is a price to be paid in terms of higher risk (which is usually measured by the volatility of share prices). In our view pension funds are uniquely positioned to pay this price due to their very long time horizons.

The potential costs to employees and pensioners of adopting a very low-risk investment strategy are very high. Lower long-term returns will ultimately result in smaller pensions and/or the requirement for higher ongoing contributions.

Risk is a two-sided coin - in Chinese the word represents danger but it also represents opportunity. Our concern is that the pension industry will miss out on the "opportunity" side of the coin of higher risk-adjusted returns, if the current seemingly exclusive focus on the "danger" side of the coin persists.

Pension Fund Investment Strategy in the Post Bubble World: Investment Faculty Ireland Limited, 2004. For a copy email fobinvest@eircom.net