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Switching to low-risk assets in crisis 'risks making all pensioners worse off'

GLOBAL - Pension funds switching to low-risk assets to guard against losses in market crises face shrinking pensions for all their members, according to a study.

European economics consultancy Oxera says changing investments to low-risk assets would be likely to slim the difference at a pension fund between those members retiring at different times.

But this is achieved by making everyone worse off, it adds.

The study finds: “If pension funds reduce their exposure to assets with short-term volatile returns, some policyholders who retire in a market downturn may be less worse off than those who retire in an upturn.

“However, all policyholders may be worse off if the pension funds generate lower returns overall due to lower-return asset allocation.”

Pension funds in Europe have changed their asset allocation in response to the current financial crisis, Oxera said.

In the second quarter of 2011, 23% of European funds said they planned to reduce their exposure to domestic equities, and 20% of funds planned to up their exposure to domestic government bonds and/or non-traditional assets, the consultancy said, citing Mercer’s annual asset allocation survey.

But there was evidence to suggest that pension funds with more equity have made a faster recovery from losses at the height of the crisis, compared with those funds with less equity, it said.

“While this pattern is not necessarily observed across the board, overall, there is a positive correlation between the proportion of equities in pension funds’ portfolios and the increase in annual returns between 2008 and 2010,” it noted.

In a simulation exercise, the consultancy used historical data to show the impact on long-term returns of 100% equity allocation strategies compared with those strategies with 100% bonds.

The pensions of individuals using a 100% equity allocation could be hard hit if they retired at the height of a crisis, it found.

But relative to individual policyholders, for pension funds, yearly variations in accumulated returns would have less impact, the consultancy points out, because the fund does not have to crystallise a reduction in accumulated returns by buying an annuity at the height of a crisis.

Rather than advocating a particular form of investment, the consultancy says the exercise aims to show generally that there is a trade-off between risk and return, and that limiting risk normally means giving up potential returns.

Overall, the challenge for the industry, it says, is to help restore consumers’ confidence in capital markets, and the develop products to mitigate the risks of short-term downturns, while pension funds continue to invest for the highest possible long-term returns.

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