UK: Focus on investment returns
Stuart Thomson argues that UK pension funds are likely to increase active LDI and alpha strategies as a result of TPR’s new objective to promote sustainable growth
The UK Pension Regulator’s annual funding statement promotes increased focus on investment returns. Academic work shows a clear relationship between current real interest rates, which are extremely low, and subsequent asset returns (beta) over the medium term. We believe trustees cannot rely wholly on beta and will need to make their assets work ever harder. One particular area we believe may come under scrutiny is the large volume of passive assets held to support LDI hedging strategies.
The Pension Regulator (TPR) recently published its annual funding statement and the new advice takes into account the provisions of the March budget, which provided the Regulator with a new objective to support “scheme funding arrangements that are compatible with sustainable growth”. The full meaning of this objective for pension funds will not be made clear until the end of the year, but the current funding statement tries to relieve, to some extent, the immediate burden on parent company contributions to pension schemes. This is achieved by reminding schemes that funding improvements should not simply be reliant on parent company contributions but also on investment returns, and also by allowing greater flexibility in the setting of recovery periods. The new funding advice relates to those schemes with valuation dates between September 2012 and September 2013, which accounts for approximately one third of all pension funds.
The move follows an international trend to relieve pressure on defined benefit pension funds and insurance companies from the impact of historically low real and nominal interest rates. Regulations have been changed in the Netherlands, Sweden, Finland and the US to help companies ignore the impact of these low discount rates. Quantitative easing purchases of government bonds by central banks and the provision of excess liquidity are designed to drive down real risk-free rates to bring forward deferred consumption and help economies escape liquidity traps.
This poses problems for insurance companies and pension funds, which have already made (often fixed) promises about future consumption. The regulatory solution has been to seek ways to allow these investors to ignore current interest rates in the hope that they will eventually revert to more acceptable valuations as their respective economies normalise from the prolonged period of post-crisis weakness.
We call this ‘post-it-note accounting’, based on the old fund manager advice to put a post-it note over the screen to avoid having to take account of adverse pricing movement in the hope that in time the trend will reverse without having to acknowledge the unrealised loss. The UK shift is more subtle and much less of a game-changer than the international rules because it does not change any of the underlying regulations. The government and the regulator’s intention is to reduce the impact of current funding issues on parent companies and ensure that funding levels reflect expected future asset returns above and beyond the negative real rates on which valuations are ultimately based.
The key phrases from the regulator have been to urge trustees to take into account what is “reasonably affordable” for company sponsors when setting contribution rates and to “agree long-term strategies with employees that protect the interests of retirement savers, whilst also enabling viable businesses to thrive and grow”. TPR says it expects funds mitigate the risks to the scheme but does not expect them to be “overly prudent”.
Furthermore, the 2013 statement suggests that “trustees can use the flexibility availability for setting the discount rate for technical reasons”, which compares with the more cautious 2012 statement, which recommended that “it is a requirement for trustees to calculate the technical provisions based on prudent assumptions, irrespective of the deficit it may reveal”.
The most concrete outcome of this policy change is to effectively eliminate the previous provision that pension funds should try to eliminate their deficits within 10 years. The investment bank consensus is that the changes are relatively minor and have been largely discounted since the government signalled its intentions in the Budget, but at the margin they imply less demand for long-dated Gilts because the approach reduces pressure to hedge liabilities.
We view this conclusion as too simplistic and the reality to be more nuanced. The request for compassionate forbearance does not alter the underlying position for the defined benefit pension funds nor the legal imperative of their fixed promise. The need for LDI hedging strategies to reduce funding level volatility remains. The need to do this on a leveraged basis and hence retain growth assets is perhaps the most obvious conclusion to be drawn from the regulator’s advice.
The Pension Protection Fund aggregate deficit of the 6,316 defined benefit pension funds in the PPF 7800 index was £134.3bn (€156.4bn) at the end of June. There were 4,692 schemes in deficit and just 1,624 in surplus. Moreover, the threat of more stringent European legislation from the European Insurance and Occupational Pensions Authority could add greater costs and deficits for defined benefit pensions over the next few years.
In attempting to close deficits, funds have three choices: seek additional contributions from the sponsoring company; improve investment returns; or, as a last resort, renegotiate liabilities. In practice, only the first two options are open to the vast majority of companies. Employers have already been increasing contributions to their pension funds; according to Capital Economics, they transferred £40bn to their pension funds last year, roughly equivalent to a third of annual investment expenditure.
More to risk assets
Government policy aims to shift the focus away from corporate contributions and onto investment performance. The most obvious impact may be a move into higher risk assets where beta can be assumed to provide surplus investment returns and hence reduce parent company contributions. However, we believe there is a large risk that beta assumptions may not be realised over the next five to 10 years. The Credit Suisse Investment Yearbook compiled by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School highlights the corrosive impact of negative real interest rates on future investment returns.
This work shows a clear, statistically significant relationship between the current real interest rate and subsequent asset returns over the medium term. The issue trustees need to be aware of is that real rates in the UK, US and Germany are all at historically low to negative levels. The current levels of real interest rates are highly stimulative for their respective economies and should facilitate a gradual return to trend growth over the next few years accompanied by higher real interest rates. However, the path towards these higher interest rates is likely to be associated with poor asset returns (beta).
Poor asset returns will limit the success of schemes relying purely on beta. We believe trustees will have to work all their assets and that alpha will become an increasingly important part of pension fund strategy. This should result in a continuing move towards move active LDI. However, we also believe the large volume of passive assets held to support LDI hedging strategies may come under scrutiny. Trustees may move towards applying active management to these assets to enhance returns.
Stuart Thomson is chief economist and co-manager of the Ignis Absolute Return Government Bond fund