What a move into bonds can mean
The recent fall in equity markets has given pension funds a very sharp reminder of the risks that equities carry and increased exposure to bonds has been seen as the most effective way of reducing this risk. Although moving out of equities into long dated sovereign debt can cut risk, significant risks will remain.
While falling equity markets have grabbed the headlines, the decline in bond yields since 1997 has also had a massive impact on the funding level of pension schemes. Yields on UK gilts, for example, have declined by more than 2% in the last five years and for those funds whose liabilities have an average life of over 20 years, that decline in yields will have had an impact on the funding level of the same order of magnitude as the declines in equity markets.
To go back to basics, the key feature of bonds is that they offer certainty of cashflow either in nominal or inflation-linked terms. Of the major investment classes only bonds offer this feature.
The liabilities of a pension scheme can also be modelled into a series of cashflows. The scheme actuary will value these cashflows with reference to bond yields and falling yields will increase the valuation of these liabilities. As bond values increase with falling yields, purchasing bonds should provide the best protection against the impact falling yields will have on the valuation of liabilities.
Although the risk will certainly be reduced by a bond orientated strategy, the cash flows generated by a bond index will bear little relationship to the cash flows of a typical pension scheme.
For many schemes a significant proportion of the cashflows will not fall due for 30 years or more. Very few bonds have maturities beyond 30 years. This means that a bond portfolio will typically generate surplus cashflows that need to be reinvested and any fund invested in a bond index will be exposed to significant interest rate risk, possibly for decades to come.
The liabilities will also incorporate some element of inflation. Some of the inflation exposure will typically be capped. As pensions cannot fall in absolute terms, the inflation exposure effectively has a floor at 0%. This would be a serious consideration should the economy experience a period of deflation. There are very few bonds that replicates this limited price indexation. A blend of fixed income and index linked bonds, where available, might provide an approximation to this exposure but as the level of inflation changes the blend that provides the best approximation is likely to change as well.
These issues can be addressed, but not through the use of bonds that are currently available. To do so will typically require the use of specialised derivative instruments, such as swap contracts with very long maturities. While swap contracts are a well established instrument in the primary markets their use by pension funds has been relatively limited to date. Also, their use raises significant legal ,tax and regulatory issues that need careful consideration.
Moving away from an ‘off the peg’ strategy, based on a blend of two or three standard indices to a portfolio that is truly tailored to the fund’s actual cashflows will require portfolio managers to adopt a different approach and develop additional skills. There will be much greater emphasis on the ability to model the actual cashflows and competence in arranging and evaluating swap contracts.
However, even when a properly qualified portfolio manager has been identified, the appropriate portfolio has been constructed and the necessary swap contracts have been entered into, significant risks will still remain – one of which is longevity risk. An increase in the life expectancy of pensioners will also have a powerful impact on the estimated value of the liabilities. There is at present no financial instrument that will hedge against this risk.
Another issue is whether it is cost effective to meet pension liabilities through investment in high quality bonds.
There are several ways of looking at this. Firstly, let us take a look at the direct consequences for the sponsoring company. The sponsor will be exposed through the balance sheet and secondly through required contributions. As many companies have discovered, an equity orientated strategy can have dire consequences for the balance sheet of the sponsor. In terms of the impact on the balance sheet and opportunity costs, a bond orientated strategy would have been much more cost effective over the last five years.
Another way of looking at the cost is in terms of the cashflow required from the sponsoring company. As actuaries tend to assume that equities will outperform bonds in the long run, an equity based strategy is assumed to meet the liabilities at a lower cost and so requires a lower level of contributions. Although the steep fall in equity markets is leading to increased contributions, the assumption of additional returns on equities remains and allows company contributions to remain below what they would be if the funds were invested only in bonds. A move away from equities is a move away from their assumed additional return and the impact on contributions can be dramatic, particularly for those funds that do not have substantial surpluses. In those cases where there is a substantial funding deficit, the contributions required following a move into good quality bonds could bankrupt the sponsoring company.
When considering the cost
effectiveness of bonds we should also consider their long term history. There is not much comfort here I am afraid. Bond yields have been low for close to five years and interest rates have reached a 40-year low. If we are indeed moving to a low inflation world such yields could be justified. But before committing to such low yields of less than 4.5%, bear in mind that inflation in the UK remains above its target level at 2.7%.
The UK government’s spending plans have been known for some time. What is starting to dawn is the realisation that tax revenues will be below Treasury projections. This means that the dearth of bonds that arguably has driven yields lower in the UK is likely to reverse sharply.
As the move into bonds will typically be out of equities, the relative value of equities and bonds should also be considered. The recent decline in UK equity prices has led to dividend yields rising to a level not seen since the beginning of 1997. Comparing UK dividend yields with gilt yields is a crude measure of the relative value of equities and bonds but this would seem to indicate that equities have not been cheaper compared to bonds since 1975.
One could argue that the equity market is simply reflecting expectations that the environment is likely to be harsher for equities in the coming years and there are no guarantees that equities will not get even cheaper. However, if the rationale for holding equities in the long run remains unaffected, the relative value looks compelling.
The advantage of a move out of equities and into bonds comes, not from reducing costs, but from reducing risk. We would argue that even with a 100% move into bonds significant risks remain and although some of these risks can be reduced, they cannot be eliminated.
A move into bonds can lead to significant increases in contribution rates particularly for those funds with deficits and so for many funds, the cost of a move into bonds would be deemed to be unacceptable. For these funds, trustees may decide that a recovery in equity markets is likely to be the only practicable means of cutting their deficit and it is only after a recovery in equity markets that a move into bonds could reduce risk without an unacceptable increase in costs.
A recovery in equities may encourage some fund trustees and sponsors to stick with an equity based strategy. We believe that others will see this as an opportunity to seek ways to reduce their risk.