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March 26, 2003

The Reward For Taking Risk
by Andrew Smithers

Equities are risky. This is why they give better long-term returns than bonds or cash. This truth was repeatedly and foolishly denied in the bubble years. People, some of whom should have known better, wrote books and articles claiming that this was not so.

However, fashions change and the old arguments are accepted once again. It was not debate that convinced, but the bear market; just the sort of thing to which Harold Macmillan, the former Prime Minister, used to refer as "events, dear boy, events."

As the realisation that equities are risky has dawned again, the question of their suitability for pension fund investment is being questioned. One thing is for sure, they are more suitable now than they were when their place was unquestioned.

Even at their new, and for new investors, improved prices it is in fact doubtful whether they belong in defined benefit pension funds. The problem is one of fairness of "equity" in its other sense.

As equities are risky they should give higher returns. So those who benefit from the higher returns should also bear the risk, or at least provide insurance to the risk takers.

In the case of defined pension funds, it is the sponsoring companies that reap the rewards of higher returns. The higher the return on the pension assets, the less the company or its members have to subscribe in new contributions. Either way the company should benefit. The better the pension benefits the less employees will need to be paid today and the less likely they are to move jobs.

The risks, however, are partly borne by the members. If the pension fund can't pay the benefits, then the first port of call is the sponsoring company. But if that goes bust, or finds some other way to avoid its pension obligations, then the risk falls on the members.

If, therefore, pension funds are invested in equities they really should be more strongly funded than if they invest in bonds. This will be expensive, in the short run at least, for companies. But it they don't chose to pay, they don't have to do so. They can have the pension fund invested in bonds. The alternative is to have defined contribution plans where the risks, together with any benefit from higher returns, are taken by the members.

Unfortunately, the need for stronger funding to insure against the risks of equity investment has not been understood by all pension advisers. When the stock market went mad, I managed to persuade a fund to sell its equities. While this has turned out very well, it should have been even better by being done earlier, were it not for the opposition of the consultants.

It seems that they told the company secretary that if the fund was not invested in equities, they would insist on higher contributions to offset the lower return that would result. Since the existing reserves cannot have been affected by funding changes, they were in fact arguing that the greater the risks the fund took, the less it would need to insure against those risks going wrong.

I fear that my experience was not unique, and that this sort of economic lunacy was common, so that several pension funds were persuaded from a sensible policy by misguided consultants.

Many pension funds now have too few assets to meet their liabilities, if properly conservative assumptions are made about the probable returns. Companies need to increase their contributions. If the consultants have learnt the lessons of the past, they will know that those funds which are invested in equities will need to increase their contributions by more than those which are invested in bonds.

This will of course be resisted. First some consultants will be unwilling to admit to past error. Second, many companies will wish to make the smallest possible increase in their contributions and will argue that markets are depressed and will bounce back. These arguments would carry greater conviction and their objectivity would seem more likely, if they were held by those who had sold out when markets were over-valued and were about to bounce down.

So long as pension funds are not properly funded, and so long as additional reserves are not required for those heavily invested in equities, there is a clear risk of a major disaster occurring, whereby a pension fund is unable to meet its obligations whilst its sponsoring company is bankrupt.

This threat has been heightened by the use of stock options. These encourage management to take greater risks and to seek to maximise short-term profits. Having under-funded pension funds heavily exposed to equities is a sure way of meeting both aims.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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