Not long after George Ross-Goobey joined the Imperial Tobacco Pension Fund in 1947, he managed to persuade his fellow fund managers that investing in gilts made little sense. The economy was beginning to grow and shares offered higher yields. He argued that because equities normally outperform bonds, investing in them would reduce pension costs. Now, surely, was the time to break from the past.
Wealthy private investors lived on the dividends of their shareholdings and expected the capital value to outpace inflation, so Imperial adopted a similar policy. The fund switched virtually all its investments into equities and, as Ross-Goobey had predicted, the capital gains led to a substantial funding surplus. Other pension funds followed suit: the so-called cult of the equity had begun.
Pensions at this time were mostly defined-benefit (DB) schemes, paying pensions at age 65 based on the length of service and final salary. The private sector paid for these upfront by building up pension funds; most of the public sector paid for theirs from ongoing contributions from existing employees. By the 1970s the funds were in surplus, which enabled generous early retirement terms and for full pensions to be paid from the age of 60.
The stock market crash of late 1973, following a sudden rise in the cost of oil, came as a shock. It brought home the risk that companies would have to top up DB funds if share prices fell and took too long to recover. Ross-Goobey changed tack and began diversifying. In 1974, he began investing in commercial property and undated government bonds, which then yielded 17 per cent.
By the mid-1980s, trustees were becoming more concerned about the general risks. There was a greater emphasis on matching pension assets with future liabilities. Actuaries started factoring in longer life expectancies. Alarmed at the potential costs, some companies began salary-averaging, or capping inflation-linked pension increases at 5 per cent. Then companies began closing their pension funds to new entrants, forcing new employees into defined-contribution (DC) schemes, which shifted the risk to individuals by making them responsible for their own pension pots.
A sea-change came in 2001, when John Ralfe, then the head of corporate finance at Boots, announced that his company's final-salary pension fund had sold out of equities entirely and moved into long-dated gilts. That locked in its surplus, reduced the risk of a potential deficit, and slashed the management costs. The initiative anticipated FRS17, which required DB pension funding to be disclosed in company balance sheets. There was a general move into gilts, which were said to be risk-free because of the government backing. And that, broadly, is where many DB pension funds still are now.
At that time, bond prices seemed to be inversely correlated with share prices, but academics warned that this relationship varied according to the economic cycle. This seemed theoretical during periods when bond prices rose as base rates declined (from over 10 per cent in 1991 to almost zero in 2020). But the shift was because of globalisation – growing cross-border supply chains held down labour costs and shrank both inflation and interest rates. In 2022, this went into reverse. Bonds fell heavily, and so did shares.
For the majority who have to fend for themselves, financial advisers traditionally rebalance DC pension pots to follow the 60/40 rule (60 per cent equities; 40 per cent bonds). As retirement nears, they also 'de-risk' by moving into gilts, which provide certainty if held to maturity (provided the government does not default). But no bond is risk-free. They might fall less than shares, but holding them increases the risk of missing out in a bull market.
Successive chancellors have added to the uncertainty by treating funds like money trees and frequently changing pension tax rules. With public sector debt about the same level as the whole of gross domestic product (GDP), Jeremy Hunt has admitted that the government now depends on selling fixed interest and index-linked gilts to pension funds. He has persuaded nine DC default pension providers to agree to invest £20bn in high-growth companies – but that means unlisted companies, private equity and start-ups, which by definition are high risk. This is dicing with other people’s money and it runs counter to the bond-buying ethos.
Investing in listed shares would be more prudent. If growth is to return to the economy, they could well generate greater returns than bonds. For both DB and DC pensions, the rationale proposed by Ross-Goobey all those years ago deserves to be seriously considered.
