Unfortunately, it is not the weather that has been hot this summer and certainly not the stockmarkets in the traditional sense. It’s more that we have all been getting very hot under the collar this summer.
We have probably all been sweating a little too much about the markets and realising there is little we can do about them. It’s an old saying that ‘quality will out’ and this has never been truer than now, but even quality companies have been put under strain.
However, at the end of the day, quality companies producing quality products and, most importantly, quality profits should be the foundation for any portfolio. But we need to know that we can believe the financial statements put out by companies. Financial engineering has got itself a very bad name. Revelations about WorldCom profit mis-statements are hardly news anymore, the real worry is about which other companies have gone down similar routes.
Another concern is the believability of broker recommendations. Research recently seems to have concentrated on just how bad broker research, or at least the officially published broker buy/sell recommendations, have been. It seems to have got to the stage where a broker buy recommendation is a sure sell sign and vice versa.
This summer has been a worrying time for most pension funds. Those funds that are immature have the consolation that they can invest new money at what appear to be bargain basement prices. But mature pension funds and over-committed investors have a big problem. Even low interest rates cannot protect investors who borrowed money to invest in the stockmarket as Martin Ebner has recently found out in Switzerland. Actually, it is amazingly ironic that one of the champions of shareholder value and full disclosure should himself have provided such rotten value and poor disclosure to his own investors. Mind you the ‘do as I say not as I do’ motto is not that unusual in investment management, especially when it comes to salaries and bonuses, but that is another story.
The biggest problem for pension funds today is their solvency and the implications of this. When markets boomed we had a virtuous circle going up, now we have a vicious circle spiralling down. Essentially, when a pension fund discovers it has a deficit because of falling equity prices, it finds it needs a contribution increase from its sponsoring company. The company will thus report lower profits and presumably be rated lower leading to a fall in its equity price. Multiplied a few times this will increase pension fund deficits requiring even higher contributions and so on. In the UK, the proposed new accounting standard on retirement benefits FRS17 has magnified this problem but the proposal to bring a similar standard internationally under IAS19 could bring the same havoc elsewhere.
The pressure on profits has increased even further in the US as a result of the demand to classify stock option costs as a profit and loss expense. Whilst this is not before time, the timing could hardly be worse for information technology companies. The only redeeming feature, if you can call it that, is that with falling markets many options are worth less than they used to be or in some cases are simply worthless. In addition, US companies are now being hit by a reversal of, what I described in February’s edition as, overly optimistic company expectations of pension fund earnings. At the time this was described, in a wonderful piece of understatement by Warren Buffet as ‘heroic’ expectations of pension fund earnings. Not only are US companies having to cope with a falling stockmarket and corporate bond defaults but they also have to unwind the return expectations for their pension fund from as high as 10% per annum!

What can pension funds do about the situation in which they now find themselves? In many cases the time for action has passed. Boots in the UK moved all of its assets into bonds over a year ago and as a result must be under much less pressure today. Many other companies, especially in the UK, are closing down their defined benefit pension schemes and transferring responsibility and risk onto their employees by moving into defined contribution pension schemes. By doing this after the market has fallen however, these actions may have simply locked in the pension fund deficit.
When markets move up it is a wonderful feeling to have a well funded pension scheme gaining the benefit of all those windfall gains but a lot of companies are now finding that they just cannot stand the pain that a poorly funded pension scheme in a falling market has on their bottom line.
I am sure more employees are unfortunately going to find out just what this will mean to their expectation of a comfortable retirement income.

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