It has been a busy autumn for UK pension funds. There has been so much going on, so many important issues to consider.
The problem is where to start commentating. One of the more fascinating subjects is the current court action between The Unilever Superannuation Fund and Merrill Lynch Investment Managers (MLIM), Unilever is suing MLIM, previously known as Mercury Asset Management, for £130m(e211m), alleging it negligently took too much risk when managing £1bn for it between January 1997 and March 1998, under a revised mandate that included a stated downside risk tolerance. MLIM is fighting the claim.
Although the risk tolerance was quoted in a contract between Unilever and MLIM it was not met by the manager. Indeed it appears from reports of the court action that at the time neither Unilever nor MLIM really understood the concept of risk management. Indeed the fund manager concerned, Alistair Lennard, was quoted in court arguing that BARRA, the device by which fund managers usually measure risk, was an inefficient tool saying he doubted its predictive abilities. He preferred to use a more subjective approach to risk control, using weekly ‘scenario planning’ sessions to establish the portfolio’s exposure to possible changes in the economic environment.
Unilever had originally asked that performance should normally be “no more than 2% below benchmark” in any four successive calendar quarters. MLIM then successfully asked for that to be changed to “no more than 3% below benchmark”. The problem for MLIM occurred in 1997 when Unilever’s pension fund undershot the performance benchmark by 8%. The problem persisted as performance went further below at 10.6% until March 1998 when Unilever’s patience finally snapped. The case continues and is being followed with much interest especially by those other pension funds who were also managed by MLIM during the period under question.
The one positive matter that might just come out of the trial is the spotlight on risk. I can see a lot more pension funds and investment managers focussing on this issue in the future. I do however believe that the general understanding of risk issues is much better in 2001 than it was in 1997.
Whether everyone really appreciates risk is of course open to doubt. An interesting recent illustration comes from the UK high street chemist Boots which has confirmed reports that it is switching its entire £2.3bn pension fund from equities to bonds to ensure its ability to cover pension payments. In a letter to members of the scheme the chairman of the Boots’ pension fund said the entire fund was now invested in the highest-quality long-dated sterling bonds. Boots claimed that it had undertaken the decision to switch into fixed-interest investments against a background of lower inflation and interest rates and increased life expectancy of its members.
The big question now being asked by the industry is whether UK pension funds are likely to desert the equity markets in favour of fixed interest bonds. Although the pension fund blamed volatile stock markets the suspicion remains that it was actually the sponsoring company that took the decision not the trustees and it was actually tough new accounting standards (essentially FRS17) that accounted for its decision to sell all its equity holdings in favour of bonds over the past 15 months.
The new rules, which will become compulsory in the UK in 2003, force companies to display differences between pension assets and liabilities on their balance sheets.
Many commentators are now warning that more companies are likely to be forced to follow the lead set by Boots. This is possible but I doubt that many will switch their entire pension fund out of equities and into fixed income securities and especially not all into corporate bonds.
I can appreciate that recent equity market falls have left big holes in pension funds but to switch an entire fund indicates that the pension fund in question does not understand proper risk management. The fund even ignores legislative requirement for proper diversification of assets. I can hardly believe that an entire fund move into bonds whilst minimising corporate accounting risk in the short term will properly minimise an underfunding risk especially as active member pension liabilities are linked to future salary levels.
One of the biggest concerns of the market however is that currently pension fund contributions are the biggest source of demand for shares on the London Stock Exchange. Any big switch from company shares could therefore have a significant market impact. Let us hope that most pension funds properly diversify their risk exposure and make rational asset allocation
decisions.
What is clear however is that company managements will take a close interest in their pension fund investment strategy. As Kerrin Rosenberg at consultants Bacon & Woodrow has pointed out these circumstances mean pension fund trustees need to be proactive in initiating investment debates with finance directors who will now be applying similar analytical techniques to those used to appraise other corporate decisions.

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