Underfunded defined benefit (DB) pension schemes in the UK are over-dependent on historically improbable equity returns, if they are to avoid carrying over funding gaps into the 2030s, according to analysis by Willis Towers Watson (WTW).
Given current funding levels, and typical asset allocations for UK pension funds, WTW research shows that the average underfunded UK DB scheme requires their equity portfolio to return 9% above cash rates on an annual basis for the whole of the next decade, or significant deficits will continue into the 2030s.
Comparing this requirement with historic returns from equities reveals how unlikely current allocations are to lead to full funding before the next decade, it said.
The analysis is based on the PPF7800 index funding ratios of underfunded UK DB pension schemes as at 31 July 2020. The funding ratio is adjusted for and assumes that pension funds are targeting full funding on a gilts flat liability basis (a proxy for targeting buyout).
Katie Sims, head of multi-asset growth solutions at WTW, said: “Underfunded DB schemes are effectively counting on a once-a-century equity performance if they’re to wipe out deficits this decade. Simply putting all your eggs in one basket and hoping for unlikely events will not be enough to solve the funding gap.”
The required rates of return for equities are almost three times the historic equivalent. UK equities have averaged just 3.1% p.a. above cash rates since comparable records started in 1704. Throughout that time, UK equities have only matched the required 9% annual rate of return over cash in 1-in-20 previous ‘rolling decades’, WTW’s research showed.
“Pension schemes need to look outside of listed equities and adopt the mindset of an endowment investor, embracing a broad range of assets including private markets, to improve their return profile,” Sims added.
“While caution is partly understandable, year by year this problem gets worse as returns will on average disappoint. Allocations that have such a low chance of delivering the right outcomes might also be seen as a form of denial. Trustees need to reimagine allocations,” she said.
She called for pension schemes and other institutional investors to “massively rethink how they anticipate creating the necessary long-term wealth to fund their future obligations”.
She noted that listed equity certainly has a place in a pension fund’s investment mix, but asset owners need to think beyond traditional allocations in order to meet the returns they need.
The analysis assumes fixed income and liability returns are in line with the UK nominal yield curve at 31 July 2020 and that schemes are fully hedging their liabilities.