The prospect of government defaults should lead pension schemes to review their approach to liability-driven investment, according to Joseph Mariathasan
At a glance
• Governments may start defaulting on their debt, explicitly or implicitly.
• That means that, long term, equity dividends could do a better job at tracking pension fund liabilities than bonds.
• Pension funds looking for income to match their liabilities may have to consider shifting back towards equities.
• Equity income also provides individual investors with more flexibility.
The idea that liability-driven investment (LDI) is purely a risk management problem rather than an investment one assumes there is a legal requirement to pay out a fixed set of cash flows. The challenge is how to ensure those liabilities can be met with as much certainty as possible.
As pension schemes become more mature, they can be paying out 6% or more of assets every year. That is well in excess of yields available on any asset. As a result they have to effectively redeem capital, points out Alasdair Macdonald, head of investment Strategy at Willis Towers Watson. That creates the risk that they are selling assets when the market has fallen, forcing them to crystallise a loss. Not many schemes are able to ignore that problem, which is the reason for ensuring future cash flows can be matched with certainty through government bonds. As a result, for most pension funds it is the mark-to-market valuation of equities that matters rather than the dividend stream.
Suppose, however, that the world moves to an environment where governments start defaulting on debt. Suddenly the characteristics of bonds would change dramatically. “That won’t be in anyone’s model at all,” says Nick Clay, a fund manager at Newton Investment Management. That would make government bonds a much more volatile asset class, while equities would be able to hold their own in a choice between income-yielding asset classes.
Clay says government defaults are a natural consequence of current trends. “The euro-zone, UK and ultimately we think most of the world’s governments are going to default on their debt.” But, he adds, there are lots of different ways of defaulting. “The Greeks do it in a very simplistic way by not giving the money back, but you can do it by inflation, or by restructuring.”
In Japan the idea has even been floated of issuing a zero coupon perpetual bond. “The current strategy is unsustainable yet central banks around the world seem utterly committed to increasing debt – trying to solve a debt problem with more debt. This is just lunacy in our view,” says Clay, adding the course of today’s central bank strategies is one that will ultimately end in default. “The only thing we don’t have an ability to forecast is the timing of that as we continue down this path but ultimately it will have to happen.”
For pension funds, the idea of default risk in euro-zone and UK government debt removes a key plank of the intellectual foundation of the conventional approach to LDI. But Macdonald also raises a more practical question. “Whatever the theoretical merits are, fundamentally if the ECB or the Bank of Japan have bought all the government bonds you can’t hold government bonds so the question becomes, what is the next best thing? Whatever you think becomes irrelevant.”
As Clay points out, over the long term, equity dividends could do a better job at tracking pension fund liabilities than bonds. An element of inflation protection is built into an equity dividend stream as corporate cash flows tend to grow in line with inflation. That is why a hypothetical UK pension fund that is still open would normally have an allocation of 40% to equities, says Macdonald. But pension funds are reducing equity allocations by about 3% a year. So over the next 10 years, most pension funds would be moving into a cash flow matching mode. Equities have just become a legacy for them.
Ironically, however, says Macdonald, we are going back to a world where it is all about income. Pension funds will be trying to find sources of secure income other than government bonds. Whether that pushes them as far as some types of equities is the question. In theory, there are some listed companies where the equity just looks like a slightly subordinated corporate bond. But quality or low-volatility companies have performed strongly, just like bonds themselves. The market is already giving high valuations to listed tobacco companies and utilities and so on that do offer a low risk income stream when bond yields are at record lows.
Pension funds may have little choice but to relook at equity income streams and their characteristics if Newton’s prognosis turns out to be correct. In any case, as Macdonald points out, investors are rapidly running out of bonds in certain markets given the rate of central bank purchases.
At a basic level, the market value of equities tends to be much more volatile than the dividend streams. Generally, about twice as much as markets go through bull and bear cycles estimates Macdonald. UK investors particularly have to be careful points out Martyn Hole, Investment Director at Capital Group – the 10 largest dividend paying companies in the UK make up 55% of the total value of dividends paid out by the FTSE 100 so there is a huge amount of concentration risk. “The total sum of dividends paid out by Royal Dutch Shell, BP and HSBC represent a third of the total value of dividends in the FTSE 100,” Hole says.
What the UK experience shows is that investors using equities for dividends should be taking a global approach. Hole points out that over the past 40-50 years dividend growth has been running at a nominal rate of 5-6% a year and in real terms at 1.5%. But it has not been a straight line upwards. There have been periods where dividends have grown less than inflation.
During the global financial crisis dividends were cut dramatically. At its worst, dividends were cut by 30% in nominal terms and 35% in real terms. But a large part of that fall was the result of huge cuts in the financial sector and particularly banks. “We saw most banks pretty much around the world either slashing dividends or cutting them altogether, as we saw with many UK-based banks,” says Hole. “So a selective approach is better, to identify those companies that can grow dividends sustainably over time.”
Investors seeking dividends do have some things in their favour. Hole points out that markets that traditionally have not been dividend-focused, such as Japan, have started paying records levels of dividends. The yield on the Japanese equity market is over 2%. The behaviour of Japanese companies with the new corporate governance and investor governance codes that the government has published in the last few years is encouraging. “Corporate governance means that companies are not so focused on just accumulating massive amounts of cash on their balance sheets but returning it to shareholders,” says Hole.
Where global equity dividend strategies become even more powerful is at the individual level where there is more flexibility to take on a limited amount of volatility. With annuity rates driven to low levels by government bond yields, it makes less sense for individuals to purchase annuities which disappear on their death. In contrast, income-producing equity strategies can be passed on to their children.
The Capital Group has seen more traction in the US than the UK in this regard. Hole sees people shifting out of risky assets too early as they approach retirement. “It makes sense to stay in dividend-paying equity portfolios as you get better income and some growth. We also have found the volatility of these portfolios tends to be quite a bit lower than just the market, around two-thirds of the market as a whole.” If the volatility of the dividend streams is half that, and the retiree has no intention of selling, then the higher yields on offer in equities can make that an easy decision.