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The Actuary The magazine of the Institute & Faculty of Actuaries

If the Boots don’t fit

David Blake and Zaki Khorasanee’s concise overview article in May, ‘Pensions funds – bonds only?’, prompts two thoughts.

First, and materially, using the Modigliani-Miller indifference argument to conclude that a 100% bond investment strategy is optimal for pension funds (owing to some second-order effects) is, as they point out, questionable. Coming at it from another angle, consider the widget-maker trying to eke out a reasonable profit from his expertise in making widgets. To compete with his rivals, he might strive to ensure that his competitive advantage in making widgets is not obscured by other random effects on his profits such as, say, higher labour costs owing to poor relative performance of pension assets. The obvious way to insure against any such unwelcome deviations in these non-competitive parts of the business is simply to copy his rivals in these aspects – copy their remuneration structure, and if this includes a defined benefit plan, copy the investment strategy. So, in accordance with the Modigliani-Miller insight, the actual investment strategy common within the industry does not matter but – and this is the key – it does not follow that the investment strategy adopted by the individual firm does not matter. It clearly matters if the widget manufacturer has systematically different wage costs to his rivals, which could happen with a radically different asset mix.

So, outside of the investment management industry, one should copy one’s competitors’ pension investment strategy and copy all the more faithfully the more financially significant the pension promise, the more labour-intensive the industry, and the greater the price sensitivity of demand of the firm’s product. Even inside the investment management industry one should pay close attention to the investment strategy of competitors, as one does not want poor relative performance jeopardising both jobs and pensions at the same time. Note that, though the end result is the same as that of Modigliani-Miller, the mechanism is fundamentally different: in the above analysis it is the consumer that ultimately bears the investment risk not, as under Modigliani-Miller, the shareholder.

Recall that in an earlier article, John Ralfe of Boots justified its current asset mix with a number of arguments (‘Why move to bonds?’, March 2002), not only the Modigliani-Miller insight. Materially, to my mind, he justified its stance as reducing mismatch risk. Boots, given its dominant market position, can perhaps dictate the pension investment strategy in its industry for reasons right or wrong, but this is not the case for most firms.

Finally, David and Zaki’s article closes with an argument based on the unfavourable outcome if everyone did the same thing, using this as a deterrent for an individual pursuing a particular course of action. I think it was Joan of Arc who answered that criticism of her chosen career with the incontrovertible retort that not everyone makes the same choice.