“It's back to school time, and maybe back to the drawing board for UK pension schemes. In July, the PPF 7800 index achieved its year to date highest funding level of 89.4%, yet during the month of August funding levels slumped back down to 87.6%. This is a familiar story now… throughout this year, the PPF 7800 funding level has bounced around a narrow range of 86-89%, unable to break higher. That is despite UK and broader world equity markets climbing by 7% and 12% respectively in 2017.
“Why the funding level rut? Schemes have been underhedged at a time when liabilities have risen faster than assets; longer dated UK real yields are 10 to 20 bps lower since the start of this year. Even this headline figure does not tell the full story –real yields moved in a 60 bp range this year – which means that a typical pension fund’s liabilities could have moved by as much as 12% between the extremes. Not hedging adequately has not just worsened funding levels this year; it’s made them materially more volatile. Lessons of previous years have obviously slipped from memories.
“Knowing how much to hedge and when is notoriously tricky. Pension schemes are striving to both reduce funding level volatility, but also hedge at a ‘good level’ of yields. Waiting for the latter can lead to inertia. We tackle the problem by setting a target “hedge ratio” that minimises funding level volatility, then let our views on rates and inflation move the target around that starting point.
“Last summer, following the UK referendum result, we increased our target hedge ratio. We decided that the near-term risks to UK economy and rates had become skewed to the downside and with so many unknowns surrounding Brexit, reducing risk should take greater priority for pension schemes. A year on, we have now lowered our hedge ratio recommendation. Why? Although Brexit-related unknowns are still very significant, yields have moved markedly lower, justifying the suggested portfolio changes we advocated in summer 2016.
“Meanwhile the global economic backdrop has greatly improved compared to a year ago, with a greater likelihood of higher future global yields. Together, they shift the risks around UK yields from being tilted to the downside to being more balanced. This warrants a more balanced risk profile for portfolios. It is important to remember that although we have lowered our hedge ratio target, we still recommend an 80% funded scheme is 65-75% hedged, for both rates and inflation - materially above the average for UK funds. After all, the best students question the status quo rather than following the pack.
“The real class swots might go one step further – and think about active LDI opportunities over and above the strategic positioning. Despite UK gilts offering less relative to swaps than in recent years, we think multi-year value can still be found in well-positioned trades across the asset swap curve and we have seen value in looking overseas for opportunities.”
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