We have had the fat years, now for the lean

TRUSTEES of the Boots pension fund have switched their portfolio out of equities. They sold at prices well above those today. This has saved millions for shareholders and improved members' security. They deserve congratulations.

Francis Thomas, at Boots, says the decision was mainly taken because of the risks, but the level of the stock market also influenced them. The decision seems soundly based on both grounds.

It used to be thought share prices were unpredictable. More recent economic work has shown this is wrong. After a prolonged period of good results, equity investment gives poor returns. The past 20 years have been very fat. Sensible pension trustees must now expect lean ones. Even over many years, lean returns can mean getting less than nothing.

In addition to the prospect of poor returns, equity investment is risky. Companies effectively guarantee defined benefit schemes. But this has no value if the firm goes bust. So members gain little and risk much if the pension fund is invested in shares.

Companies also take the risks. But at least they stand to gain if things go well. They should be asking two questions: whether this is the right time to take such risks and whether these are the right sort of risks to take.

Pension liabilities do not rise and fall with share prices. When funds are invested in shares, companies must pay up even if returns are poor. This has always been true, but there are four reasons to be extra wary now.

The first is that returns have been above average for the past 20 years. The second is that inflation is less of a threat than it was. The third is that many pension funds are mature and have shorter time horizons than before. Finally, new accounting rules will make it harder to 'hide' the losses.

Business is not about avoiding risk, but managing it. Investing the pension fund in shares is one way of taking risks. It is one, however, over which the firm has little control. Stock market risks are among the least manageable ones that a company faces.

A company can gear itself up directly, by borrowing on its own balance sheet. It can do it indirectly, by investing the pension fund in equities. The tax benefits used to be fairly even handed. Interest on a company's debts was an allowable expense for corporation tax, but pension funds could reclaim the advanced corporation tax on the dividends.

The tax benefit of company gearing is still there, but Chancellor Gordon Brown has abolished ACT. From a tax viewpoint, it now makes more sense to have direct rather than indirect leverage.

Pension funds own around a quarter of the UK equity market. If they sell, the period of poor returns is likely to be short and sharp.

www.smithers.co.uk