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Cheer up, it might not happen

What a difference a year makes. Investment committees have been pleasantly surprised by a fairly benign asset growth period from the Trump election onwards. 

Brexit and the US election result last November led to a period of investor caution as investors sat on their hands while they digested the perceived ramifications. Investment activity slowed to a trickle.

While investors should not overlook the long-term implications of Brexit or Trump’s policies, the short-term effects have not been as wildly negative as many feared and a more positive ‘Trump trade’ view on equities has persisted this year.  There is less concern about QE tapering in the US and, in the longer term, in Europe. 

In credit, while there are widespread concerns about some valuations, there is no immediate alarm, given low levels of defaults and the absence of any real boom that would exacerbate the risk of a bust. 

What questions should investment committees now ask themselves and their external advisers? One concerns the right level of risk in the portfolio. As they mature, pension funds generally become more vulnerable to investment shocks, given that the capacity of a cashflow-negative scheme to repair drawdowns is less than that of a cashflow-positive fund.

While no metric exists as to the ‘right’ level of risk for a given set of assets and liabilities, pension funds have been pushing the boundaries of their risk tolerance in a number of countries as they seek to increase funding levels.

Is this itself a cause for concern? Risk-taking capacity and capability is a hallmark of pension funds; while for some CFOs and sponsors, the idea of a (near) risk-free portfolio may seem attractive, the associated cost, in terms of higher immediate contributions to create capital buffers or to pay the premium for a buyout, usually does not.

Smoothing out the ultimate cost of pensions by allowing future capital market returns to take up the slack removes pressure from current members and shareholders of corporate sponsors, either or both of whom will bear the costs. 

Yet there are concerns that pension funds, with their current levels or risk, are vulnerable to downside shocks. As the credit crunch and the subsequent Lehman Brothers collapse fade into history, it will be important to remember the value of investment beliefs and nimble behaviour when the time comes to switch in or out of asset classes.

Concentration and herd behaviour serves investors and pension funds badly. This they should consciously avoid. At the same time, they should be prepared for a storm in every hope that none comes soon. So for pension fund boards the message is as follows: assess risk levels, retain if necessary but review governance procedures and investment beliefs. They should provide an invaluable guide as and when there is a shock.

Liam Kennedy, Editor
liam.kennedy@ipe.com

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