Having been forced to shelter from recent market storms in the relative safety of high-quality bonds, there is growing debate about whether defined-benefit (DB) pension funds may be set to boost allocations to assets with the potential for higher returns. This has been fuelled by buoyant stock markets with indices across the world edging closer to record highs. However, there remain a number of reasons to question whether the DB pensions flotilla is likely to venture quickly beyond the harbour walls.
Let us first examine the situation facing pension funds. DB schemes have been steadily increasing their bond exposures and reducing their equity holdings since the mid-1990s. In the UK, equity weighting fell below 40% during 2012, compared to an 80% peak two decades earlier. The core driver of this change was initially regulatory, as accounting reform drove the focus towards marking-to-market liabilities using long-term yields. During the financial crisis the trend accelerated as share prices fell and portfolios were not rebalanced. More recently it was exacerbated by tactical allocations towards corporate bonds offering attractive yields. Such history is important as it shows how breaking recent patterns requires both a reversal of regulatory trends and also a challenging of investment conventions.
Of course, pressures for change are growing. For example, the pension deficit of S&P 500 companies is estimated to have risen from $337 billion at the end of 2011 to $412 billion by the end of 2012, despite the MSCI EAFE returning 18% and the S&P 500 13% last year. Since 1998, there has been a nearly 25% expansion of the deficit between global pensions and liabilities. The falls in global stock markets in 2008-09 were certainly one of the drivers of this trend. Another has been the regime change in monetary policy witnessed in the aftermath of the global financial crisis.
While QE has helped to drive some investors towards higher yielding assets, such as credit and equities, other implications have been less favourable for pension schemes. Fund liabilities are typically calculated using a discount rate derived from yields on a universe of high quality bonds. Unconventional policy action and subsequent fund flows have suppressed bond yields, with the net effect of lowering discount rates and raising liabilities. Hence, in the UK the discount rate for the industry standard index of AA-rated bonds averaged just 4.1% per annum at the end of 2012, compared to 4.6% a year earler. Each 0.5% per annum fall in the discount rate adds around 10% to liabilities for schemes with a duration of around 20 years. US pension fund deficits rose $74 billion during last year for this reason.
One response is to re-examine the conventions about calculating discount rates. We have already seen some companies adopt a wider bond universe, with greater innovation in terms of the size and characteristics or the use of multiple rating agencies. In Europe, several governments have announced reviews of the rules governing discount rates to provide support for schemes. However, attempts to adapt the current policy environment are complicated by uncertainty over how long ultra-loose policies will be sustained. Interestingly, during January the combination of a rise in interest expectations plus strong equity market returns had the effect of a $106 billion improvement in the funding status of the 100 largest US corporate pension plans, the second largest monthly rise on record. Central bankers and bond investors are attempting to weigh the speed of the economic recovery, inflation pressures and the risks from too sharp a sell off in fixed income markets. In this environment, it is no surprise that major asset allocation decisions are being postponed until greater clarity on the direction of policy is available.
A continued source of uncertainty for pension funds is the regulatory environment. A whole gamut of issues is currently up for debate across global pension markets. In Europe, proposals to reform legisation covering the occupational pension sector through the Institutions for Occupational Retirement Provision (IORP) directive are symptomatic of the challenges posed by pension legislation. Hoping to capture better the financial exposures of pension funds, the European pensions’ regulator has proposed a ‘holisitic balance sheet approach’ to liabilities calculation. However, after numerous papers and consultations over a decade, there still remains considerable vocal opposition to these proposals. In the UK, this new approach is estimated to increase outstanding pension liabilities by 33%, while the rise in Holland is estimated at 26%. Similar increases are forecast for Belgium, Germany and Ireland. On top of this, there is a genuine fear among pension industry bodies that IORP harmonisation of the capital regime for pension funds wth that of banks and insurers would actually increase systemic risk, by driving all major asset allocators to respond in the same way to any major event. The debate will continue, but this example serves to highlight the pressures on pension funds globally from regulatory change.
In the current environment, it is no surprise that some observers argue that a shift into risk assets may help pension schemes. Certainly, a change in the interest rate environment and an end to unconventional monetary policy may make a material difference to discount rates and liabilities, as indicated in the January data for the US. However, there remain serious doubts as to whether these two factors can provide more than just short-term relief for an industry undergoing substantive change. More importantly, it may be the wrong medicine at a time when many DB pension funds are cashflow negative and are looking to navigate a complicated end-game, rather than boost risk in their funds. Indeed, there may be a case for some pension funds to use the current rally in equity markets as an opportunity to shift away from risk assets at an even faster pace than previously, as the imperative for de-risking intensifies.
In conclusion, it seems unlikely that a dramatic U-turn in equity allocations by pension funds lies ahead. Even for those who see a recovery in global growth as a signal for greater optimism about the outlook for share prices, the policy and regulatory environment is likely to sustain the current risk aversion. Alongside the extension of the search for sustainable yield beyond credit into growth-oriented assets, it seems that absolute return, alternatives and bond type assets are likely to remain the preferred options in a diversified portfolio.
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