EUROPE - Approximately 80% of European pension schemes will increase their allocations to inflation-linked and inflation-sensitive assets as quantitative easing and government stimulus programmes create inflation anxiety.

However, according to a survey of 1,100 mainly defined benefit pension funds by Mercer, low yields on government bonds are strengthening the trend toward alternative debt markets, including distressed and mezzanine debt, as well as high yield and emerging-market debt.

According to the report, 18% of pension schemes concerned about inflation intend to increase their allocation to inflation-linked bonds, 5% to inflation-sensitive assets and 3% to inflation swaps.

Many within the remaining 12%, reluctant to invest at current market levels, have instead set up monitoring processes that will enable them to increase their exposure.

Even pension funds with a historical bias toward equities, such as those in the UK and Ireland, are shifting toward fixed income.

In the UK, this has been most marked in the domestic equity portfolio, down from 28% in 2009 to 21% now. 

Irish funds' allocations - domestic and otherwise - have fallen from 59% in 2010 to 50% in 2011.

According to the report, 23% of European funds - and 35% of UK funds - intend to reduce their equities portfolios over the next 12 months.

Over the same period, 22% of European pension funds will increase their allocations to emerging market debt, while 6% intend to increase their allocations to distressed debt.

One reason for the increased focus on emerging market debt has been a decline in the perception of European sovereign debt as a risk-free asset.

Although the largest European pension schemes have slightly reduced their domestic corporate bond exposure, large pension schemes have increased theirs to domestic and overseas corporate bonds.

Small and medium-sized pension schemes have increased their allocation to domestic corporate bonds.

The report said: "As the average allocation to bonds increases, plans are looking to diversify their bond exposure away from investment-grade bonds in search of higher yields."

It forecast that domestic government bonds and non-traditional asset classes would be the most popular destinations for European pension fund investment over the next 12 months.

However, despite the continuing focus on yields, scenario testing will become increasingly important in the design of investment strategies as pension schemes strive to build portfolios able to withstand contingent outcomes.

The schemes polled account for more than €550bn in assets under management. Almost 50% of those included in the survey are relatively small schemes with less than €50m in assets under management.