Puritans vs Anglicans

February 2010

The revelations that the Church of England pension scheme committed 100% of its portfolio to equities, resulting in a deficit of £352m (on liabilities of £813m) after the horrors of 2008, have reawakened the debate about asset allocation.

To use a religious metaphor, this debate pits the puritans against the Anglicans. The Puritans, led by ex-Boots corporate finance man John Ralfe, think that pension funds should match assets with liabilities. Since liabilities are bond-like, that means pension funds should own government bonds, preferably of the index-linked type. The alternative is to risk hellfire and damnation, in the form of an equity bear market and pensions shortfalls.

The Anglicans feel this is far too restrictive. We can all muddle through as we did in the past, believing that equities will deliver the highest returns over the long run, as theory suggests they should. For if the corporate sector is not delivering a return higher than the risk-free rate, then the economy is in deep trouble. If a pension fund has a long-enough time horizon, it can sit out short-term fluctuations. We can have our reward in heaven, in the form of good pensions, while still having fun on Earth.

The Anglican view is very tempting for those funding pension schemes. Given the low return on government bonds, a Puritanical approach implies high contributions. But the Puritans would argue that trusting in the equity risk premium is like believing in a free lunch; investors focus on the potentially high rewards from stockmarkets and forget about the risk.

Three factors often get forgotten in this great debate. The first is that, in all the argument about DB allocation, no-one talks about DC. The employee may be happy for a DB scheme to take a bit of risk, on the grounds that the employer will top the fund up if things go wrong. In a DC scheme, the employee bears all the risk. That ought to suggest a more conservative allocation. But default funds tend to have a heavy equity bias.

The second issue is the function of private sector pension schemes. They are supposed to prevent future pensioners from being a burden on the taxpayer. But if all the assets of the fund are invested in government bonds, then the pensions will in effect be paid by future taxes.

The third issue is whether government bonds are really risk-free. In a world of soaring budget deficits, one has to take the possibility of government default seriously. There were 16 defaults by European governments in the 20th century. Even the British government swapped a higher-yielding issue for a lower-yielding issue (a partial default) between the wars. And on some long-dated index-linked issues, the British government has the right to change the inflation measure.

Investors need to consider whether risk-free assets might need to include the issues of other, more prudent governments. Germany is an obvious example. Foreign exchange risk is a problem but debt default tends to be accompanied by currency crises; if UK finances do get out of control, sterling will plunge. And gold needs to be given some consideration as an asset that is no-one’s liability.