Although pension funds are told that their natural matching asset class is bonds, many UK pension fund trustees are still reluctant to accept that fact. Twenty or more years of heavy and often increasing exposure to equities conditioned many trustees to overly rely on them. For a long time high real rates of return were provided and taken for granted and even now surveys of pension fund executives and trustees continue to show an expectation of high returns if one looks at forecasts of index levels over the next year or so. We seem to continue to be too optimistic – is this just wishful thinking rather than true analysis?
Unfortunately, the market collapse over the last three years has brought down average equity returns over the last 10 years to levels not seen in most trustees’ professional experience. We have entered new territory and in the UK we have to rethink the way we make asset allocation decisions. According to commentators such as Jon Exley of Mercer Investment Consulting, the mere fact that pension liabilities most closely match bonds is sufficient reason for pension funds to invest all of their assets in bonds. Other commentators such as Craig Gillespie from Watson Wyatt believe that as a 100% investment in bonds would not eliminate risk then there is still a place for equity investment.
The reason bonds cannot provide the perfect match for pension funds is that their duration is not long enough; re-investment of income carries risk; in retirement, pensions are often tied to inflation and in their build up phase, pensions are tied to earnings. In addition to all this, our pensioners do seem to be living longer and there is no way of offsetting an unexpected longevity risk.
For all of these reasons equities or other bond alternatives still have a place. The big question is at what level equites should feature in pension fund portfolios. Watson Wyatt believe that a minimum risk portfolio, whilst depending on a fund’s views and structure, is more likely to contain 10% to 20% in equities rather than zero.
For most funds a more reasonable starting point for bond exposure will be 50% of assets. Now even this is a revolution in the UK. Whereas most pension funds in continental Europe start with bonds and look hard to justify investment outside of this asset class into equities and property; for the last 20 or so years in the UK, too many funds started with a 100% exposure to equities and worked hard to justify even a small deviation to invest in bonds or other asset classes.
Now there is always a danger of over-compensation. Given that the investment industry seems to be one of the very few that has its consumers seemingly inevitably buying at the wrong time with too many people buying high and selling low. In addition, we always seem to want to sack managers who are about to outperform in order to appoint managers after they have performed well and past their peak!
So do we really want to be investing in bonds at the prices currently available? With bond yields at very low levels, even lower in many cases than equity yields, it apparently makes little sense to sell equities in order to buy bonds. But, rumour has it that many funds have made a decision in principle to reallocate more of their assets from equities into bonds. All that they require before enacting the decision is for the equity market to recover. Unfortunately, it hasn’t.
However, if there really is this overhang then how can the market recover and if it doesn‚t recover quickly, could pension funds be forced to sell equities at any price? If true, this could force the market lower still in the short term! Although there certainly appears to have been a rush into the safe haven of bonds, there could be more to come.
So have funds missed the boat. Many pension funds, measuring assets at market value, are in deficit. Sponsoring companies will struggle to make up this deficit and if they do have to pay additional contributions, this will reduce profits, possibly reduce dividends and inevitably force down prices. Some pension funds waiting for the market to recover before reallocating assets could end up bitterly disappointed. After all, equity prices in Japan are only about 20% of where they stood in the late 1980s! Maybe more funds should be following CalPERs’ lead of putting more money into hedge funds. There are alternatives these days to long only quoted equity investment. Actually the key for most funds should be diversification. We have seen what too heavy a dependence on equities can produce it would be not be sane to potentially repeat the mistake with any other asset class.