Time for an overhaul
With yields rising and pension schemes continuing to increase their allocation to bonds, Peter Ball asks how trustees can plug the deficit in their schemes
In recent years, UK pension schemes have been subject to increasing regulatory pressures, historically low interest rates and low investment returns, resulting in large funding deficits. Some suggest that the road to recovery could be paved with higher discount rates. Be careful what you wish for.
Our research into the FTSE350 companies’ pension schemes shows the average allocation to bonds has increased from 33% to 56% since 2007. This trend, albeit natural for maturing schemes, has exposed them to potential significant capital losses should yields rise, as they have been, on longer-dated Gilts, since May 2013.
What should schemes do in this environment? The unexciting answer is, it depends. Now, more than ever, trustees need to assess their schemes’ outlook from the point of view of a comprehensive risk management framework. One thing is clear: to deal with the deficits, their bond portfolios will need an overhaul. The way to do it will depend on their view on yields.
In the hypothetical world of a never-ending quantitative easing (QE), the risk of interest rates suddenly going up and inflicting capital depreciation is low – but schemes will then be grappling with seemingly unsustainable funding deficits. These deficits could be decreased if they work their bond portfolios harder and smarter. Our view is that fixed-interest Gilts for such schemes could be replaced with an allocation to multi-asset credit strategies. Such a move will leave some duration on the table, provide for a degree of matching to liabilities and also yield an attractive 5-7% per annum.
This strategy would not withstand the end of QE and a rise in yields. In that eventuality, trustees may need to adopt a defensive capital strategy and protect their relatively high bond asset values by ‘eliminating’ duration, perhaps through a switch to an absolute return bond fund (aiming to return cash plus 2-4% while being largely immune to interest rate changes), or an allocation to senior secured loans (with an expected return of about 6% based on a floating cash rate).
Both strategies would lead to an increase in the funding level volatility, sheltering schemes from rising rates but leaving them vulnerable should the rates fall further. But both are viable, provided trustees understand the risks they are currently running in their schemes and the risks they are taking on: any proposed transformation should be right for their schemes, both in light of their funding position and the strength of the employer covenant.
Having considered the bond assets, attention turns to the growth part of the portfolio. We believe that pension schemes should have significant investments in emerging markets and that recent weakness provides an excellent opportunity to buy in the coming months. For trustees concerned that an allocation to emerging markets could leave their schemes exposed to further negative returns in the short term, an allocation to frontier markets could be a compelling alternative.
Frontier markets exhibit a range of characteristics that support the economic case for investment, including strong demographics, rich natural resources, a growing middle class and lower public and private sector debt than Western economies. These characteristics are driving growth now and will drive future investment returns. And while past performance can’t be relied on for the future, frontier markets have recently supported this view, having returned +25.7% in the 12 months to 31 August 2013, exceeding the return from developed markets by more than four percentage points.
Frontier market equities provide portfolio construction benefits too: low correlation with developed markets and lower volatility than both developed and emerging markets.
Frontier markets also provide higher dividend yields. In valuation terms, the market is trading today at more than 30% less than its previous peak seen in 2007. However, capacity is limited, so schemes should act now to gain exposure because in the challenging post-crisis landscape, this is one area that we believe is poised for growth, offering a much needed return-boosting opportunity for pension schemes.
In the current environment, trustees would be wise to assess the risks inherent in their schemes and choose a deficit reduction strategy that would be most suitable for protecting their matching portfolios while enhancing returns from the growth assets.
Peter Ball is managing director at JLT Employee Benefits