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May 31, 2004

The Coming Revolution: Equity Return Assumptions Cratering, Stocks Cratering

By Kathryn M. Welling

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Andrew Smithers and his financial economics research firm, Smithers & Co., are based in London. His perspective has focused lately on pension plans. And his suggested changes would rock markets. I probed his thinking recently and got an earful. He summed up the prevailing investment climate pretty neatly at the close of a speech he gave in Scotland to the U.K's National Association of Pension

Funds. Smithers cited what he dubbed "Smithers' Law: Bad forecasts drive out good.'"

Is it really all that bad? You did, after all, find an audience?

I'm actually quite pleased with the reaction I got when I gave the talk up in Edinburgh. First of all, when you tell people unpleasant things, it's nice not to have cabbages and tomatoes thrown at you. Second, I got a lot of excellent questions from that audience, I thought. Ones that indicated people were seeking illumination, rather than simply reacting with hostility. In fact, I think there is a widespread concern in the U.K. about pension financing issues. And that has been causing a lot of other people to make points that are not all that dissimilar from mine, albeit from slightly different angles. Notably, a former finance director of Boots took his whole pension fund out of equities at a very clever level in terms of the market and has been preaching, since then, the benefits that companies can get from putting their pension funds into bonds and putting more leverage on their balance sheets.

He's preaching the joy of leverage, did you say?

Yes. Not more leverage overall, but of putting more of what leverage exists on balance sheets. Because, of course, by doing so, you can greatly increase your tax benefits. What I am saying is that if you treat - as I think you should - the equity risk of the pension fund as a liability of the company - because the equity risk in a defined benefit pension plan is borne by the sponsoring company - then the balance sheets of the pension fund and the company really should be consolidated. What this implies is that for the corporate sector as a whole, the holding of equities in defined benefit pension funds is a form of disguised (or off-balance sheet) leverage.

The Boots pension fund got some ink in the U.S. when it abandoned equities - but again, mostly in terms of "Look at those batty Brits."

Yes, we all are. But the real problem is that we have a significant number of quite large companies in the U.K. that are very, very seriously in a hole in terms of their pension funds. And I suspect a similar situation exists in the United States. These are situations in which - if someone were taking a strictly objective view - he would say that these companies should have very large rights issues. They should then put a great deal of money into their pension funds to fill up their gaps. Then they should invest the money in bonds.

You're talking about the leverage of the corporate sector as a whole being unchanged - but not the leverage of specific companies.