Today's Autumn Statement paints a picture of a challenging environment for UK pension funds. Though Chancellor Hammond has, as anticipated, broken from some of the objectives of ex-Chancellor Osborne and modestly loosened the fiscal purse strings, the Office for Budget Responsibility's (OBR's) estimates suggest post-Brexit Britain will experience lower growth than was previously forecast. This low-growth future could restrict the ability of the average UK pension fund sponsor to support schemes that run into difficulties. We believe many pension funds are taking too much risk in this uncertain environment - particularly with regards to interest rates.
UK corporate pension fund deficits widened to all-time highs in the months following the UK's decision to leave the European Union. Government bond yields fell materially following the Bank of England's stimulus announced in August, increasing pension fund liabilities. Though nominal UK yields have since retraced, due to higher inflation expectations being priced in following Sterling’s depreciation and market anticipation of "Trumpflation", UK real yields remain below their pre-Brexit levels. The extra borrowing announced by the Chancellor today will lead to welcome additional supply of long-dated hedging assets, to relieve some of the downward pressure on yields. In our view, however, this is not enough to materially shift the path of UK real yields over a medium-term time horizon. The colossal latent demand from pension funds for long-dated hedging assets far exceeds the additional supply that will stem from today's announcements. Pension funds cannot rely on rising yields to escape their funding holes.
Though no silver bullets exist, the Chancellor's announcement of new infrastructure projects highlights one avenue of opportunity for pension funds to begin to claw back their deficits. A natural advantage for pension funds, relative to many other investors, is their greater ability to hold illiquid assets. Infrastructure and other private market real assets may offer long term investors higher returns through an illiquidity premium, diversification from correlated public markets and an attractive cashflow stream - sometimes inflation-linked. Strict regulatory rules mean some of these assets are out of bounds for insurers due to the capital charges they would incur - but such rules impact pension funds less. Real assets can be a strong match to projected liability cashflows, and are materially cheaper than traditional matching assets - and we believe most pension funds should be holding a greater allocation to these assets than they currently do. Today's announcements do not result in the immediate provision of new assets other than gilts, as the borrowing to fund the new investments will be done on the government’s own balance sheet. However, the statement also suggested a potential future role for the private sector in infrastructure projects. Any increase in the future supply of infrastructure assets accessible to pension funds would be welcome.
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