UK/US – Defined benefit pension schemes should seriously consider the case of a zero allocation to equities, particularly in the case of indexed equities, says a report by UBS Investment Research.

The report, by UBS analysts Stephen Cooper and David Bianco, concludes that the case against equity investment for corporate defined benefit schemes to be “robust and worthy of serious consideration”.

Their theory is based on the idea that equities prevent optimal corporate capital structures. With regards to tax considerations and capital structure, pension funds are better off investing in fixed income say the analysts.

“From a shareholder value perspective it would be better to replace pension leverage with more tax efficient financial leverage in the company’s capital structure.”

Other factors mentioned in the report are: benefit leakage for those funds which are close to being over-funded; risk for underfunded schemes; high correlation of equities to macro business conditions and profitability.

For those pension funds that choose to forgo tax-related capital structure advantages and invest in equities, active management is required, and alpha strategies should be pursued. “If the fund managers can successfully generate long-term alpha then it is true that equity investment may add value. If fund managers cannot generate alpha, the fund should switch to fixed income and not to indexed equities,” says the report.

Cooper and Bianco admit that their theory is controversial. Indeed UK company Boots is the only fund to have opted for a zero allocation to equities. However, UBS believes that upcoming changes in accounting rules in the US and Europe which will increase transparency of risk and cost of pensions provisions will encourage pension funds to reduce their strategic equity allocations.

The title of the report is “Pension fund asset allocation: Should pension funds invest in equities?”.