The Boots pension scheme is one of the 50 largest UK pension funds, with 72,000 members and £2.3bn of assets (e3.75bn). A move last year to invest 100% of the fund’s assets in long dated bonds, however, made it one of the country’s, if not the continent’s, most talked about pension plans.
As of April 2000, the fund’s assets comprised 75% equities, 20% short-term traded bonds and 5% cash – the average for UK pension funds.
However, over the 15 months to July 2001, the fund sold all its equities and short-term bonds and shifted entirely into long-dated sterling bonds. These bonds have virtually no credit risk, as they are AAA/Aaa sovereign issuers and a close match for the maturity and indexation of pension liabilities, with a weighted average maturity of 30 years and 25% index-linked bonds. The bonds are held to maturity, with no trading and re-investment of net income.
This move by Boots from equities to matching bonds turned pension fund conventional wisdom on its head, since UK company pension funds had been invested heavily in equities for a generation. The “cult of the equity” appeared to have served them well, with an apparently reliable long-term out-performance from UK and world equity markets over the last 20 years.
Boots’ rejection of the cult-of-the-equity was based, unashamedly, on financial economics. The conclusion that pension assets and liabilities should be matched, with UK and US pension funds holding bonds not equities, has been standard corporate finance textbook stuff, going back to the 1980s.
For Boots, the switch from equities to matching bonds was a bold and positive step for the company, its shareholders, creditors and scheme members. Firstly, it reduced Boots’ financial risk by matching pension assets and liabilities. The matched bonds move very closely in line with the value of pension liabilities, drastically reducing the risk and potential size of any deficit. Moving to 100% matched bonds locks in a surplus of assets over accrued pension liabilities. This surplus is expected to maintain the long term company pension contributions at £50m pa in real terms.
Secondly, the shift reduced management charges and dealing costs, which for a £2bn largely equity fund were very significant at about 0.5% or £10m per annum. These have been reduced to £0.3m for the bond portfolio. The new strategy also reduced the costs of management time and effort by the company and trustees, including compliance costs.
Finally, the transition increased security for pension scheme members by matching pension assets and liabilities, meaning that the value of assets should be enough to pay all pensions, regardless of any movements in financial markets. For Boots, going well beyond the legal minimum underlines the importance the company places on its pension promise to scheme members.
In the year since the move was announced, Boots Pensions has been able to increase its inflation linked assets to 0% through interest rate swaps, with maturities from 2016 to 2030, giving a better match for the pension guarantees of up to 5% pa.
The company has also completed a £300m share buyback, made possible by moving to matching bonds. Reducing risk “off balance sheet” in the pension fund has allowed Boots to increase risk “on balance sheet”, without weakening the current credit rating.
During 2002, the value of pension assets has increased and the assets continue to be enough to pay all accrued pensions. Had the fund still been in equities there would be a major shortfall that could only have been met by increased company contributions.
Over the last two years the world has also been brutally reminded that equities are not a one-way bet.
Furthermore, all UK companies have reported under the first stage of the new accounting standard, FRS 17 over the last year, showing many of them with deficits. The aggregate shortfall in UK pension funds has been estimated at £100bn. Shareholders and the credit rating agencies are starting to ask questions.
While pension scheme risk will become more apparent as FRS 17 is adopted by all UK corporations, Boots is showing the way to shareholders, creditors and pension scheme members, who will expect this risk to be properly managed.

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