For everyone managing pension funds, or their investments, or indeed managing our own retirement planning, one of the greatest challenges is to maintain a focus on achieving long-term strategic goals amid the constant buffeting of contradictory news and the distraction of more pressing concerns.
Like captains of ships in uncharted waters, we have to navigate between many immediate obstacles and distinguish between the squalls to sit out and the more substantial weather fronts against which we need to take action.
The immediate drivers for the current low interest rate environment – initially aimed at bringing stability to the banking system and now stimulating economic growth – led some to interpret this state of affairs as a short term phenomenon, one to sit out rather than address. Indeed, many investors see the current monetary environment as unsustainable, and have consequently parked their money in the apparent safety of the short end of the yield curve.
However, understanding current monetary policy in terms of financial repression offers a deeper insight into what pension funds and investors, large or small, should expect:
By enabling the issuance of sovereign debt at artificially low interest rates, which offer investors low-to-negative real returns, governments can in effect liquidate some of the public debt. For governments wary of the political strictures of fiscal policy (a modern government only has so much leeway to raise taxes, introduce austerity and retain power), financial repression offers a subtler means of debt reduction, albeit through an effective tax on savers and their savings.
Financial repression is insidious; it takes time before its effects are seen. Historic examples, such as in the US after the Second World War when debt reached 122% of GDP, point to it being a policy response measured over years, maybe even decades. Investors cannot rely on a return to the old world. It is more likely that the end of quantitative easing and subsequent increase in interest rates will be later and more gradual than many predict, characterised by central banks’ willingness to be behind the curve with respect to inflation.
Financial repression forces us to accept that there is no alternative but to invest in risk assets to achieve long-term returns; that the pursuit of short-term safety is leading to long-term risks.
Such was the backdrop to this year’s Allianz-Oxford Pensions conference, where we discussed the implications for pension funds of investing during a period of financial repression. A strong mix of senior practitioners and academics from around the world participated in the conference, where we covered a range of immediate and longer-term challenges facing the worlds of both defined benefit (DB) and defined contribution (DC) schemes.
Beginning with a focus on DB, there was consistency among experts on the principles for pension fund investing, namely: safety, stability, transparency and a drive for adequacy. Yet there was also divergence in how to deliver on those principles, caused in large part by regulatory and accounting tensions as well as differences in national governments’ frameworks for DB pension provision.
New regulations (actual or threatened) and (potential) accounting standards, combine to create an unintended backdraft in an era of financial repression. For example, even if pensions industry has won a stay of execution from IORP II’s planned solvency requirements, there is the risk that pension funds could yet end up having to invest more in the assets most adversely impacted by financial repression, and in the process lock in an inability to generate the long-term returns needed to meet future obligations. Such policy would surely sound the death knell for many DB schemes, battered already by storms.
Notwithstanding these pressures and concerns, there was recognition that, at a time of lower returns, pension funds need to find ways of bridging the gap between the returns from a classic balanced portfolio, generating 3%, and the reality of needing up to 7% to meet future liabilities.
We heard from healthy pension funds, that have managed to reposition their portfolios towards a broader range of assets, but acknowledged that with this comes complexity and cost beyond the reach of most medium and smaller funds’ governance budget.
There are potential opportunities arising from bank deleveraging: investments in real assets such as infrastructure, direct loans and mortgages are being increasingly considered by funds. As long-term investors, pension funds are well placed to take advantage of investments that offer illiquidity premia. They are able to use derivatives and risk management tools to limit volatility within their funds – provided costs do not become prohibitive. We heard, however, that resources, governance and skills need to keep pace with the greater demand for expertise.
Arising from the discussions, we could surmise a hypothetical ‘smart risk’ approach as having four key elements covering both return and risk considerations:
• First, funds will need to increase the average allocation to risky assets that provide the potential to achieve the desired target return.
• Second, they should add uncorrelated sources of sustainable alpha to increase the return potential for low risk budget consumption – but make sure they are uncorrelated.
• Third, the allocation should be broadly and globally diversified to reduce risk; and to protect against inflation, real assets should be included.
• Finally, the risk would ideally be managed dynamically to reduce losses while maintaining upside potential.
While the question facing DB schemes might be described as one of sustainability, when it comes to DC the question is one of adequacy and viability. With the risk for retirement provision transferred from employer to the individual, and as a growing number of DC participants approach retirement, there is a real danger than many people will struggle to meet future income needs.
For the increasing proportion of people whose prosperity in retirement will depend on defined contribution investments and other personal savings, the conference considered some of the behavioural challenges facing individuals, in particular inherent attitudes towards risk and the relationship between age and loss aversion, the importance of framing and the power of anchoring.
There was broad agreement that developing an appropriate architecture, focused more on outcomes than inputs, together with an emphasis on transparency and communication will be critical.
While demography and intergenerational inequality represent unknown factors, they will nevertheless need to be addressed in national policy frameworks, and make adequate pension provision both an economic and social imperative.
Increasingly, the pensions landscape can be separated into the ‘haves’ and the ‘have nots’ – between those with the relative comfort of a DB plan, and the growing majority struggling to make DC work in a world of volatility and low returns.
The next challenge facing the industry may well relate to the difficult choices available to individuals as to when and how they can elect to create and draw on retirement income. There is currently an inadequate range of annuitisation options available. It is a complex decision at an emotional time and it could be argued that compulsory annuitisation without advice, such as in the UK, may be doing the public a disservice.
Drawing again on behavioural science, we should be thinking more holistically about income lifecycles, encompassing both accumulation and decumulation phases while avoiding or minimising the vesting cliff. Brave words but a bold contribution to improve outcomes for DC scheme members will be necessary to avoid the damaging consequences of not optimising income in retirement.