Unforeseen consequences: Keiron Root finds that Gordon Brown's tinkering with pension tax relief has held back the UK stock market

What Investment, June, 2007 by Keiron Root

One decision that has come back to haunt Gordon Brown with a vengeance in recent weeks is the abolition of the tax credit for advance corporation tax (ACT) early in New Labour's first term, and the subsequent impact that this has had on the values of Britain's pension funds.

I am indebted to Paul Killik of stockbroker Killik and Co, who sent me a copy of a detailed analysis of the impact that the removal of ACT had on pension fund savings that he prepared a couple of years ago. In it, he argued that, although the chancellor was roundly criticised at the time ACT relief was removed, the ongoing effects have been even more significant.

As Killik says, 'The yield on the whole market effectively fell by 20 per cent.' The reason that it didn't seem to matter very much at the time was that the two years after the change, 1998 and 1999, saw the stock market continuing its steady climb on the back of the tech bubble. Again, as Killik points out, 'Yield is of little consequence when a market is rising strongly. However, once the bear market started, yield came to the fore as, along with assets, it is the safety net, and the ultimate protection for equities.'

He even goes so far as to suggest that the sharp falls in the early years of the current decade were made considerably worse by the fact that the market was yielding significantly less than it had been. There was also a knock-on effect from the initial fall in markets. Life assurance and pension funds had to sell more equities to meet their liquidity requirements and so a vicious circle was set up which depressed the stock market even further.

Killik calculated that rather than the FTSE 100 getting below 3,300 before the rally finally started, if the tax credits had not been removed, the recovery should have started when it hit 4,100, even allowing for the same levels of institutional forced selling that we actually saw. Given that these would probably not have been required if the recovery started sooner, the index could have bounced at an even higher level.

Killik's conclusion was that not only did the removal of ACT credits take 5 billion [pounds sterling] a year, and rising, from investors, it led directly to the destruction of as much as 300 billion [pounds sterling] of stock market value.

Of course, this figure is conjecture, but the basic argument is sound enough. It also helps to explain why, despite Gordon Brown frequently reminding us how well the UK's economy has performed over the past decade, its stock market has generally lagged behind the rest of the world.

And this at a time when Aon Consulting reports that the combined accounting deficit of the UK's 200 largest pension schemes has fallen to 14 billion [pounds sterling], with 30 per cent of those schemes now in surplus. The improvement in the health of many pension schemes is due to a combination of better market returns and more prudent (where have I heard that word before?) investment policies. But Aon also points out that, if ACT relief had not been removed, the combined figure would now show a surplus of 6 billion [pounds sterling]. Mr Brown's "stealth tax" has cost these pension funds 20 billion [pounds sterling].

Aon also points out that movement in the size of deficits can be extremely volatile--weekly shifts of 5 billion [pounds sterling] or more are common--and that 'The impact of the volatility of pension scheme valuations on employers' balance sheets continues to be a major cause for concern.'

Given that the chancellor's excuse for removing ACT relief was to encourage greater investment in UK businesses, there is a degree of irony behind this increased uncertainty. It is to be hoped that those companies that still offer their employees a defined-benefit pension scheme--and they are a dwindling band--have learnt another important lesson of recent history, should they be in the fortunate position of returning to surplus in their pension funds.

As Joseph famously told Pharaoh, surpluses do not last for ever and you must set aside some of the excess you receive in the good years to help you through. the lean times.