Daily Archives: February 29, 2012

Two reminders of the age-old debate over the merits of equities versus bonds emerged almost simultaneously in recent days.

First, Warren Buffett argued in his latest annual letter that shares are not only a better investment than fixed income instruments but are also superior to gold, the darling of many seasoned investors.

Just as that was being digested, the Financial Times reported that the Ford Motor Company had decided to put 80 per cent of its pension plan assets into bonds, up from 45 per cent previously.

While Ford makes great cars, I believe they got this decision wrong. In doing so, they fell prey to the classic mistake that many investors make: basing decisions on recent past performance rather than a more balanced view of long-term history and a clear vision of the future.

I’m betting that Mr Buffett will be proved correct. Over a reasonable period of time, shares will almost surely outperform fixed income instruments. (If they don’t, centuries of finance theory will have to be discarded.)

It’s easy to see why some investors might be tempted to go down Ford’s path. Over the past five- and 10-year periods, the US stock market (as measured by the Standard & Poor’s 500 index) has substantially underperformed the fixed income market (as measured by the BarCap index).

How dispiriting it must be for an investor to have endured the stomach-wrenching rollercoaster of equities over these periods, only to find himself at the short end of the stick. But as painful as a decade of only marginal share price gains must feel, the longer term picture is quite clear. Go back, for example, 35 years. Stocks have risen an average of 10.8 per cent per year since then, while the bond index has risen by 8.2 per cent annually.

That might not sound like a huge difference but as Mr Buffett regularly observes, the power of compounding can be immense. An investment of $10,000 in shares 35 years ago would be worth $366,756 today. The same sum put into bonds would be worth less than half that at $157,234.

Personally, I don’t imagine that either stocks or bonds will match the past 35 years over the next 35 years (or even a shorter period). Both investment routes benefited enormously from a steady reduction in interest rates as the stagflationary environment of the 1970s was dealt with.

But by almost any measure, stocks today are cheaper than bonds. For example, the S&P index trades at a 14.1 times multiple of most recent 12-month earnings, compared to an average of 16.8 times since 1977. Meanwhile, thanks to de minimus inflation and accommodating monetary policy, bond yields are near an all-time low.

Perhaps most dramatically – and almost without historical precedent – the dividend yield on the S&P index is currently higher than the 10-year Treasury yield. Either stocks are cheap or a lot of companies will soon be reducing their payouts.

If proved wrong, Ford would be among a lengthy and illustrious list of investors who turned away from shares at the wrong moment. In August 1979, for example, BusinessWeek magazine emblazoned “The Death of Equities” across its cover. An extraordinary US bull market began just seven months later.

Why is investing perhaps the only profession that non-professionals think they can do themselves? Few of us would try to be our own lawyers or doctors.

Mr Buffett shouldn’t be making cars and Ford shouldn’t be making investment decisions.

The writer is former head of the task force that oversaw the bail-out of Chrysler and General Motors

Response by Zvi Bodie and John Ralfe

Ford is right to match its pensions assets and liabilities

Steven Rattner takes Ford Motors to task for its plan to move 80 per cent of its pension fund into bonds, arguing that over any “reasonable period” equities will outperform bonds and that equities currently look cheap versus bonds.

There is no question that equities have a higher expected return than bonds. However, the “equity risk premium” is not a free lunch for investors. It’s a reward for the higher risk of holding equities, which unlike bonds, have no fixed annual payments or fixed redemption date or value. (A higher expected return says nothing about actual returns, which have been ugly in the last decade).

What about Mr Rattner’s anecdotal evidence that historically high multiples and low yields mean equities now look cheap versus bonds? Some of us believe that all information is already in the price of any financial asset, through investors buying and selling at the margin, so would argue that the likelihood of being able to outguess the market, over any period, is always 50/50.

But, whether equities are currently cheap or not is a red herring. Any individual investor who agrees that equities are cheap can themselves sell bonds and buy equities. They do not need Ford, or any other company, to do it on their behalf. This is an extension of the Modigliani Miller theorem, that increasing the leverage of a firm has, absent tax, no first order benefit for shareholders, since they can achieve the same level of leverage themselves directly. Equally by holding equities in its pension fund a company is doing nothing its shareholders cannot do themselves directly.

Ford’s decision is not an investment call based on the relative value of equities and bonds. It is a strategic decision to reduce its overall financial risk, by holding assets to better match its liability to pay pensioners over many decades. Matching pension assets and liabilities reduces the likelihood that it will have to make unwelcome deficit contributions, probably at a time when it can least afford them. Pensions are a major risk for Ford. Its total pension liabilities of $74bn, dwarf its $50bn market capitalisation.

Holding equities in the pension fund increases a company’s financial risk and gearing. It is exactly the same as the company issuing long dated bonds and investing the proceeds into a mutual fund. Would Mr Rattner advocate this as a strategy for Ford or other companies?

What about the tax implications of holding equities in the pension fund? By having financial risk in its pension fund, rather than on balance sheet though higher borrowings, a company is being tax inefficient, as interest payments on debt are tax deductible. The late Fischer Black, way back in 1980, recognised this in a paper advocating that companies should match their pension liabilities with bonds and then gear up on balance sheet by increasing debt.

Furthermore, in the UK, it is more tax efficient for private individuals to hold equities directly, because the dividend tax credit, which was abolished for pension funds in 1997, is still payable to individuals.

Matching pension assets and liabilities also reduces risk for scheme members, as the value of pension assets should always be enough to pay all pensions, regardless of movements in financial markets.

The UK is ahead of the US in recognising the risk of holding equities in company pension funds, and in matching pension assets and liabilities. Most famous is the case of Boots, which in 2001 moved its entire £2.4bn pension fund into long dated AAA/Aaa sovereign bonds. It then did a £300m share buyback to have risk on the balance sheet.

Mr Rattner is right that Ford should make cars, not investment decisions. A better match of its pension assets and liabilities takes a major risk and distraction off the table, allowing Ford’s management to concentrate on doing just that.

Zvi Bodie is professor of management at Boston University, and John Ralfe is a UK-based pension consultant and former head of corporate finance at Boots

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