Bumpy flights have predictable and unpredictable outcomes: you know the ride will be more uncomfortable and some of the passengers may be sick. You just don’t know precisely when you’re going to hit the turbulence, or whether you or the person next to you is going to be the one who needs the sick bag. You might end up landing at a different airport altogether if the flight is diverted.
We are now undoubtedly on a very bumpy economic ride with profound implications for pensions. Economic storm clouds have been gathering for months, and it is no exaggeration to contend that we may (potentially) be on the brink of an economic disaster. The range of outcomes is wide - from the possibility of a Greek default inside the euro, to a far more catastrophic euro break up, or a major global depression.
Assuming, for the purposes of this argument, a situation of poor growth and a double-dip recession, along with continued bank stress but not outright disaster, pension funds are braced for turbulence and arguably much better placed to survive it than they were in the run-up to 2008.
A number of high-profile commentators have been warning, since the recovery set in from early 2009, that we exist in a ‘fat-tailed’ world in which economic crisis and financial market volatility is to be expected more frequently than in the previous 20 or 30 years. That message has been well heeded by pension funds, and has been reinforced in the Netherlands by the pensions regulator. Across Europe, most pension funds sold Greek and/or peripheral euro debt as far back as 2009 and many have extremely low weightings to sovereign debt outright.
More generally, pension funds have set about on a course of portfolio diversification involving greater allocations to alternatives and emerging markets, for instance, and less to developed market, long-only equities. Enhanced risk management frameworks - developed either in-house in the case of large institutions or with consultants and fiduciary managers - have been put into place, typically involving pre-defined trigger mechanisms for de-risking and re-risking.
The portfolio and risk maintenance work undertaken since 2009 have had a positive outcome. Pension funds have (so far) largely avoided the disastrous underfunding seen in 2008-09, although they remain vulnerable.
Still, pension funds that predicted a stronger recovery, rising interest rates and rising risk asset classes have been proved wrong. In the UK, that means the flight path to full settlement through insurance buyout, if planned, is further away than funds and their sponsors predicted.
This change in horizon has profound implications for asset allocation. Where funds might have fought shy of illiquidity in areas such as private equity or infrastructure, in anticipation of a buyout over the medium term, they may now have more of an illiquidity risk budget than first planned. It might be time for some to put the illiquidity premium to work for them.
Perhaps the most predictable outcome of the current financial turbulence is that there will be no shortage of pain as we come out of the crisis. And despite the best efforts of pension funds to maintain coverage ratios, many are moving from net cashflow positive to net payout status, which itself dampens risk budgets and makes it harder to climb to a better funding position.
Where pension outcomes are dependent on the coverage position of the pension fund, such as in the Netherlands for inflation indexation, times are likely to be hard. For employers and active members of all pension funds, contributions will have to increase to pay for a pension that could previously have been afforded for less.
It might not yet be time to adopt the brace position but the ride is likely to stay bumpy for some time to come.