THE PENSIONS SHAKE-UP AND EQUITY DEMAND / THE FINANCIAL TIMES ( RECOMMENDED READING )

The pensions shake-up and equity demand

Published: March 9 2010 18:38

Where will demand for equities come from in the coming decade?

The decline of defined benefit pension provision in the US and UK, prompted by tougher regulation and mark-to-market accounting, has accelerated a shift away from more risky investments, a move that was set to happen in a more measured way as populations grew older. Meanwhile, company share registers in the English-speaking countries are increasingly dominated by foreign investors.

In the UK, domestic pension funds and life assurers have run down their share of the UK equity market to 25-30 per cent.

Lindsay Tomlinson, chairman of the  National Association of Pension Funds, worries that there is no natural domestic buyer of UK equities and that the pension funds are being turned into forced buyers of government debt. He is not alone in thinking that the domestic market share will continue to fall.

The question is whether this matters in today’s globalised market place.

In an economy closed to external equity investors, such as the UK before 1979, the decline of defined benefit pensions would have been a disaster. The cost and availability of equity capital would have reflected the reduced flow of funds into the equity market. This potential concern became irrelevant as a consequence of the lifting of exchange controls and the globalisation of capital flows, which made the market more efficient while putting downward pressure on the cost of capital.

The corporate sector in the English-speaking world, where funded pensions are the norm, has not had to worry about a changed allocation of assets in the pension system because it coincided with the fashion for cross-border diversification. In effect, the British are in a similar position to the big continental European economies, where a dearth of funded pension schemes has meant share registers are often dominated by foreign investors.

Because the pool of US pension money is so vast, it takes very little diversification by Americans to have a big impact on smaller economies like the UK even if that pool is contracting.

The shift to bonds coincided with the credit-fuelled growth of private equity, whose appetite for corporate acquisitions shrank the stock of equity before the credit crunch cut privateers down to size.

Another source of demand came from the rapid accumulation of reserves in Asia and the petro-economies. Reserve managers have sought to raise the return on these funds by increasing exposure to risk.

Hence the rise of sovereign wealth funds, which have been active in developed world equity. They would prefer to invest more in emerging markets. But since these are small, such mega-funds turn to the deeper markets of North America and Europe.

The question is whether worrying about an imbalance of the supply and demand for equity is worth the bother.

Markets are adjustment mechanisms and shock absorbers. They equilibrate supply and demand. Few would have forecast the rapidity of the build-up of cross-border flows, or that China and other developing countries would pile up reserves in excess of what they needed to defend their currencies from hot money outflows. Nor is it easy to forecast how long their excess savings habit will last.

The future shape of pension provision in these countries – the mix between public and private, funded and pay-as-you-go, defined benefit and defined contribution – will have a vital impact on demand for the different classes of assets. Yet it is inherently unforecastable.

There are grounds for worry when a country becomes heavily dependent on foreign equity flows. Overseas investors tend to be more footloose and less committed owners than domestic institutions.

When considering a bid such as Kraft’s offer for Cadbury, their judgment may be more short-term and narrowly financial than that of domestic counterparts, which is one of Mr Tomlinson’s concerns.

Foreign investors share the institutional urge to move in herds. When they make for the exit, it can be destabilising for currencies as well as stock markets.

The short-term focus of many fund managers can make for a reluctance to engage with companies. They are inhibited in addressing governance issues by the difficulties of cross-border voting.

A problem would arise if investors developed a homing instinct because cross-border diversification has failed to deliver on its promise of reducing risk by offering uncorrelated returns.

Equally problematic would be a strong regulatory or cultural home bias in the newer pension funds of fast-growing developing countries.

But there is no cause for panic. This is more a niggling worry than a red alert.

John Plender is an FT columnist

Copyright The Financial Times Limited 2010.