Most notably, the UBS Investment Research report says that equity investments in pension funds inefficiently leverage the position of shareholders. Thus, looking at the idea from the perspective of the shareholder, ” it would be better to replace pension leverage with more tax efficient financial leverage in the company’s capital structure,” the report –Pension fund asset allocation: Should pension funds invest in equities?– says.
Rather, corporate pension funds should invest in bonds, say UBS analysts Stephen Cooper and David Bianco, the authors of the report. Their theory is based on the idea that equity investments in pension funds prevent optimal corporate capital structures and that bonds provide better tax considerations. Thus, companies that have currently large equity positions in their pension funds would add value by replacing this “pension leverage” with more efficient financial leverage in their corporate capital structure.
For example, UBS says only debt provides an interest tax shield. Also, interest rates are heavily influenced by the taxes paid by corporate bondholders. Thus, since equity returns are generally taxed at lower rates than bonds, there is less of an advantage to being a tax-qualified investor when investing in equities, the report finds.
Recognizing that corporate shareholders might desire exposure to equities, the report suggests, “those shareholders should buy more equities directly.”
UBS recognizes a certain love affair pension funds currently have with equity investments and says for those companies that cannot tear themselves away from these positions to instead consider utilizing “alpha strategies” such as market timing or stock selection. In this case, where pension fund managers could find a way to generate long-term alpha, then equity investments could overcome their own inefficiencies and generate a positive return for the fund, and ultimately the corporate shareholders, UBS said.
Compounding the problem, UBS points to greater shareholder risk by virtue of a larger investment division – pension assets – relative to the size of the company – equity market capitalization. In this case, the bigger they are, the harder they fall in respect to equity investments. “The bigger the fund, the more difficult it is likely to be to generate sufficient alpha to offset the equity investment inefficiencies,” the report says.
Other factors mentioned in the report to limit equity exposure in pension funds:
- benefit leakage for those funds that are close to being overfunded
- risk for underfunded plans
- high correlation of equities to macro business conditions and profitability.
Prompting this suggested move completely out of equity investments is the potential for future changes in pension fund accounting that UBS said will remove the bias that current pension account standards reward companies that invest in equities with higher profit. In the US the current rule governing pension accounting standards, FAS No 87, has come under fire for its language regarding “smoothing.” (See Smooth Move ) and could see a potential change in the coming months (See FASB Puts Pension Disclosure On The Agenda ).
Additionally, UBS sees possible impetus in the likelihood the Pension Benefit Guaranty Corporation (PBGC) will move toward a risk-based determination system – a system that considers the size and financial health of the company sponsoring the plan and the volatility of plan assets.
However, UBS admits that this plan is not without controversy: “we recognize the controversial nature of the subject and the wide range of opinions held, even among our colleagues.”