Just how low can our shares go?

'Pension funds missed a chance to sell equities when there were buyers. Now they're selling for what they can get'

The statistics about the present pension fund liabilities of UK companies are fascinating. Watson Wyatt, the consultants, say in May last year pension funds of UK public companies, in aggregate, were fully funded. In other words, if last May you had made the calculations required by the controversial new accounting standard FRS 17 (to be introduced in full in 2005 but at present a footnote requirement), UK companies would have had no need to record a pension fund liability on their collective balance sheet. Assets and liabilities were roughly in balance.

But by the end of September last year, with the stock market touching new lows, and gilt yields falling, this picture had changed dramatically. Instead of having no collective pension fund liability, UK plc was suddenly facing an aggregate pension fund liability of no less than £150bn. By the end of the year, with the market recovering a little before Christmas, this figure had come down to a "mere" £130bn.

The figure companies have to provide is the difference between two much larger sums and, by definition, is based on estimates of what a fund's assets and liabilities will be over a period of many years.

Whatever method you use, this is never going to be a precise science (as evidenced by Morgan Stanley, for example, this week estimating the present pension fund liability of UK companies at £85bn, which is little more than half the Watson Wyatt figure).

If the figure can change by so much in just four months, and vary so much from one calculation to the next, you can certainly say this is not a meaningful exercise. Under FRS 17, companies whose year-end happens to be June, for example, could end up appearing in the pink of health while other companies with September year-ends appear to be in deep diddly-squat, merely because of what happened to markets in the intervening three months.

But the more interesting point about Watson Wyatt's figures is that they underline how wedded pension funds have become to the cult of the equity.

For many years, it has been traditional practice for pension funds to have the majority of their assets (up to 75 per cent in many cases) in shares. This is on the traditional grounds that equities are the proven best medium for investors with long-term horizons and real [above inflation] liabilities. The higher long-run returns from equities compensate for their much greater volatility compared with other asset classes.

This formula worked well while markets were booming. The long bull market of the Eighties and Nineties produced a string of bumper years for pension funds. The average pension fund produced a return of 10 per cent over the 30 years 1972-2001.

Now, of course, the bear market has thrown all these calculations into reverse. If you have 75 per cent of your assets in an asset class as volatile as shares, and the market falls by 50 per cent in three years, it is inevitable that it will have a big impact. That UK plc can swing from balance to a net pension fund liability of £150bn in just four months is testimony enough.

While the stock market was still as highly valued as it was at the height of the bubble, a sharp fall in the market was much easier for pension funds to live with. But now the market has fallen as far as it has (we are now back to end-1995 levels and may be going lower still) it is beginning to cause real distress in the pension fund community. Many pension funds are more exposed to the stock market's fall than life assurance companies, whose problems with living with the market at present levels have been well documented in recent months.

If Sir Howard Davies, of the Financial Services Authority, is right that most life assurance companies can live with the Footsie index at 3500, but that several will start to run into problems if it goes to 3000, you can be certain pension funds are hurting every bit as much. All the big institutions are caught in a painful dilemma. Most have been big net sellers of equities in the last 12 to 18 months. They know selling into a falling market runs the risk of becoming a self-fulfilling downward spiral. But like filmgoers trapped in a cinema when the cry of "Fire" goes up, they are learning how hard it is to make an orderly retreat from a potential inferno. The core of the problem is not that share prices are falling, but that the stock market at 3500 is a fundamentally different ballgame from the market at 5000.

How low can it go? One senior stockbroker said he would not be surprised to see the Footsie index drop below 3000 before this phase of the bear market has run its course. In my view, the odds are more finely balanced than that. It is possible, given the uncertainties of the Iraqi situation, and investors' general nervousness, that we will see both 3000 and 4000 within a relatively short period. On the other hand, experienced investors say that buying the stock market when it yields 4.1 per cent (as it did at one point this week) has never failed to produce a decent long-term return. The chances are that it will do so again, to the benefit of anyone who has the courage and a strong enough balance sheet to withstand the embarrassment of further falls in the short term. The smart money says we could have another decent rally from where we are today.

The trouble for most pension funds and life companies is that they no longer feel they can afford to take such a robust long view. Fad-followers at the best of times, they find it safer to hunt in packs. Many missed the opportunity to lighten their equity weightings at the top of the market when there were ready buyers in abundance. Now they are selling for whatever they can get to whoever they can find.

The pity of it all though is that while private investors can in theory make more sensible adjustments to their portfolios than big institutions (being less hide-bound by rules and the straitjacket of conventional wisdom), pension funds and insurance companies still have more of our money than we do ourselves.

Those buying shares for the first time in years with a genuine prospect of making medium-term gains are merely buying them back from the providers of their own pension funds and endowments, a curious and troubling thought.

¿ For some unfathomable reason, last week I mistakenly said the title of Leon Levy's memoirs was The Mind of The Market. In fact the book is called The Mind of Wall Street and is published by the Public Affairs imprint in New York. My apologies to anyone who has tried to obtain a copy without success.

davisbiz@aol.com