One year on and the job of trustees gathered at the United Kingdom’s National Association of Pension Funds, NAPF, annual investment conference in Edinburgh hasn’t got any easier. As the search for optimism in a low-return world endures, the conference seems to be caught in a time loop. Compared to last year, deciding on the best allocations is just as tricky, liabilities have got worse, the impact of longevity on investment strategies is still worrying and inconclusive, and complex and costly regulation threatens just as tight a stranglehold. Trustees say they face the same old problems. The grim outlook suggests the time has come to start doing things differently, and some funds have responded with an encouraging sense of adventure.
Anyone for an equity ride?
However, any glimmer of hope that the resurgence in equity markets could signal better long-term returns, or the beginnings of a great rotation from bonds to equities, was snuffed out early on by the London Business School’s Professor Paul Marsh. Based on stock-market data gathered over the last 100 years, Marsh and his colleagues don’t expect equities to generate any more than 3-per-cent returns for the next 30 years. He predicts a structural shift in the pension landscape as schemes merge, managers are paid less and contribution rates rise. “You shouldn’t live in denial that equities can bail you out,” he said. “Those managers that are saying they can produce 7-to-10 per cent a year should shade them down. Pension schemes in the US forecasting equity returns of 10 per cent are plain crazy.”
Even without the gloomy historical context, managers trying to drum up enthusiasm among trustees for a bumpy ride with equities have their work cut out. Apart from the biggest pension funds, like the £34-billion ($50.68-billion) University Superannuation Scheme, which has a higher than average 54-per-cent equity allocation, most UK schemes now hold more bonds than equities. A decade ago they owned 20 per cent of the FTSE. Of course schemes that rely on defined contribution by individuals still like equity assets, but defined-benefit schemes will continue to shun stocks, match liabilities and hedge against inflation with UK inflation-linked gilts, says Martin Mannion, chairman of NAPF and director of pensions finance and risk for pharmaceutical group GlaxoSmithKline’s UK pension scheme. In a vicious circle, de-risking defined-benefit schemes’ steady flock from equities to fixed income will have an increasingly profound impact on growth and economic activity for the UK’s biggest companies.
No gilt lily
But gilts aren’t necessarily the answer either. In the words of one delegate, trustees are crossing their fingers and hoping, rather than grasping the nettle. Everyone knows how the price of gilts has been driven up by funds’ searches for safe havens and successive rounds of quantitative easing. It has exacerbated the pressure on prices and yields, with many pension funds seeing their deficits increase as yields plummet. To add to the problem, anticipated rises in UK interest rates – at historic lows for years now – means the bond outlook is growing darker with a forecast fall in prices and the worry for funds of losing money.
The alternative long-term adventure
Alternative investments for closing and maturing defined-benefit schemes after long-dated and illiquid assets could be corporate bonds, real estate and infrastructure with inflation-protection characteristics. The answer for other schemes has to be bigger global allocations and more investment in non-traditional asset classes. Funds should revisit their risk appetite in search of returns and adopt a more flexible approach to their asset allocation. Tilt portfolios towards emerging markets or give up liquidity and invest longer for bigger rewards.
Encouragingly, schemes are getting more adventurous. Non-traditional assets now account for 15 per cent of a typical defined-benefit scheme’s asset allocation and more schemes are investing in new diversified growth funds. Assets managed by diversified growth funds in the UK and Ireland rose form $45 billion to $75 billion last year, according to consultancy Aon Hewitt. Funds are also adapting to changed times, such as the planned merger of London’s local authority schemes into one giant fund to create an economy of scale and pack more investment clout.
In the grand scheme of NAPF’s 90-year life, the current poor returns are just a snapshot on a long roll of film. For all today’s angst, pension funds have been investing and paying pensions through world wars, recessions, tumult and innovation and that’s not going to change. But pension funds, cautious and ponderous by nature, must not be gripped by paralysis. As long as the outlook is unsettled, funds should diversify their risks and spread their bets or we’ll all be back in the same place again next year.