“In June, the PPF 7800 Index rose from 86.8% to 89.1%; both asset and liability values fell but fortunately for pension schemes liabilities fell by more. The 88% mark has been hit several times this year only to slip away soon after but each time it was short lived; is this time different? The Lions secured a glorious draw with the All Blacks at the weekend against the odds. It wasn’t by luck but by covering their weak spots and not repeating mistakes. Will pension schemes do the same?
“Liability values dropped in June due to sharp rises in both real and nominal gilt yields. An underhedged scheme could take the yield rise as vindication and maintain their stance. Alternately – and more shrewdly – they could compare this rise to others experienced over the last year and take a more balanced view. Learning from the past should lead schemes to hedge opportunistically when yields rise and take the small wins, rather than being heroic and waiting for the perfect level. What the last 10 years should have taught pension schemes is that it is the volatility of the liabilities that is critical to funded status, not that of the assets – the case for more LDI for many schemes is overwhelming.
“But aren’t yields too low? Not necessarily. Much like the Lions’ celebrated draw, the perception of any result depends on the perception of the starting point (in their case - expected defeat). Pension schemes making hedging decisions should similarly view the prospect of rising yields in the context of their starting point. If a scheme is starting from an ‘underhedged’ position then an expectation that yields will rise should not preclude hedging more today. It is all about sizing this “bet” appropriately. For many schemes, hedge ratios can be increased to a level that still means they can gain from rising yields, but ensures they are not taking excessive risk to any one particular driver of returns. For schemes that are more hedged, the starting point and challenges are different and arguably more nuanced, especially for schemes with deficits and with negative cashflow. Getting the right balance of risk between under-hedging, risk drivers of return-seeking assets and the cash generative power of different assets, is today’s key challenge.
“Biasing towards higher hedging levels and allocating to private market investments – both of which we advocate – are views that appear to be shared by the Pension Protection Fund (PPF), the lifeboat fund for defined benefit (DB) pension schemes, when it invests its own money. The fund recorded a 16% investment return over the 12 months to March, but with liability driven investment excluded the return was only 3.9%. Though investing in private markets comes at the cost of lower liquidity, the majority of pension schemes have a sufficiently long investment horizon to tolerate low liquidity. Moreover, their longer investment horizon can give pension schemes an advantage over other potential investors. The PPF has a significant portfolio allocation to alternative assets; with a 22.5% weighting, ranging from private equity to farmland. We think many schemes should own a larger share of less liquid assets than they currently do.”
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