Rates of change
For UK defined benefit pension schemes 2013 was a great year. In January 2014, we estimated in our inaugural survey of the FTSE 350 market that funding levels had risen roughly 10%, to 103%. While we did not expect such double-digit gains this year, our negative outlook on government interest rates and our bullish tilt toward developed market equities clearly expressed a view that markets should continue to help funding levels rise. However, our recommendation was clear: maintain (or create) a long-term de-risking plan, lock in profits from 2013, don’t bank on long-dated rates to rise much in the short term, and don’t have exposure to unnecessary market risk. As we said back in January, “this is no time to relax”.
Now nearly six months into the year, we review how both our market predictions and strategy have fared. Our positive outlook on developed market return-generating assets is slowly being validated, with developed equity markets broadly up for the year after a torrid January. Unpredictable stock sector performance, the harshest US winter in living memory and fears around Chinese growth have scared investors and led to fairly flat asset price returns, with the MSCI World index returning only 0.5% to mid-May. Volatility during this period was at its highest level since the US ‘fiscal cliff’ concerns in 2012. Emerging market equities are still down for the year. High-quality bond markets have outperformed equities and the strengthening of sterling has weighed negatively on returns generated outside of the UK.
However, contrary to our predictions, 30-year Gilt yields, which have a significant impact on the present value of pension liabilities, have fallen by nearly 0.25 percentage points. For an average scheme, that would translate into a 4% rise in obligations. This flies in the face of quite positive economic data (the most recent figures show the economy growing at an annualised rate of 3.2%), consumer sentiment and our own forecasts. It gives real credence to our cautionary note in January to focus on a long-term de-risking strategy.
The question is why more schemes do not follow this advice. Many, particularly those with fewer assets or limited resources, are under-allocated to liability-hedging assets, given their funding level. This may, in large part, be because trustees were waiting for bond yields to rise further before implementing more hedging.
The market experience year-to-date, with the economy growing but interest rates not moving, reiterates the need for trustees to focus on long-term strategy. Regardless of market views or momentum after a good year, sticking to a strong de-risking framework is paramount to protecting funding levels. It allows schemes to strike the correct balance between liability-hedging and return-generating assets, maintaining a risk stance appropriate for the funding level. To this end, we believe that triggers based on funding levels are more outcome-oriented than triggers based on yields.
A framework with bands around these triggers to allow for market views is important, but the overall strategy should be one of systematically locking in gains in funding status. In addition, using active management to generate returns above liabilities looks increasingly attractive as markets are less driven by the ‘risk-on, risk-off’ mentality prevalent a few years ago. Instrument selection, credit or relative value views can all be additive.
While liability-hedging strategies are an important component to de-risking, we recognise that most schemes still need to generate real returns in excess of the liability discount rate to close funding gaps. These schemes can implement de-risking strategies on the return-generating portion of the portfolio. Greater diversification away from equities into alternatives or return-generating assets with some liability-hedging characteristics – such as inflation-sensitive equities, real estate debt and a range of credit assets – can reduce funding status volatility without compromising on returns. Looking holistically at assets and liabilities allows one to take account of the duration or inflation sensitivity of assets in the return-generating portfolio when thinking about the liability hedge ratio. In terms of hedging out other unwanted market risks, we continue to hedge some emerging market risk for our clients, remain overweight only specific developed market equities and are underweight commodities.
Unlike last year, 2014 has not started with strong tailwinds for pension schemes. We feel vindicated in our call to not ‘relax’ yet. Locking in gains in funding levels now seems prescient. We continue to seek a combination of robust diversification within the return-generating portfolio and systematic long-term de-risking for the overall scheme. This is a potentially powerful way of mitigating funding level volatility in uncertain markets.
Carolyn Tavares is executive director, global portfolio solutions, at Goldman Sachs Asset Management.