Perhaps aptly for the month in which Halloween falls, markets got spooked in October. 2018 seems destined to repeat itself, with a period of reasonable equity returns and improving funding levels being eroded by market volatility. As in February and August, October saw funding levels fall from previous highs to 93.6%, lower than the start of the year, and the aggregate deficit of all schemes nearly tripled over the month to £107.7 billion. Like these previous months, this was largely driven by falling asset values as a result of equity market volatility. Equity markets fell to levels not seen since the beginning of the year, driven by tighter financial conditions and elevated worries about the impact of heightened U.S.- China trade tensions, which also sent credit spreads wider. For pension schemes, asset falls were compounded by liabilities rising due to declining gilt yields (10 and 30-year yields falling c.13 and 4bps to 1.46% and 1.91% respectively) and increased inflation expectations (up 8bps to 3.35%) reinforcing our call for trustees to build greater resilience into their portfolios.
October saw the latest UK Budget released. Despite the announcement that the Government is signalling the end of austerity with spending due to rise, the Chancellor intends to continue reducing the proportion of index-linked gilt issuance. While this has had a limited immediate impact on the yield curve as it was largely priced in, for pension schemes with inflation linked liabilities this is clearly an area to watch. A reduction in supply could put further downward pressure on yields as prices rise, making it harder for schemes to hedge these liabilities at a reasonable cost. Furthermore, with a stronger indication that the government intends to move away from RPI as its key measure of inflation there is the possibility that at some point RPI could be replaced, something which could have an impact on those schemes that currently use it as a measure for valuing their pension benefits.
Throughout October, those schemes with well-balanced and managed strategies fared better and their funding levels may even have increased if they had sufficient hedging and dynamic growth portfolios. Those schemes which had taken advantage of funding level improvements earlier in the year by de-risking will be sitting happier than those which hadn’t. Moreover, recent volatility has highlighted that now is the time to look beyond benchmarking alone to provide protection for tail risks. Instead, schemes should be looking for more diversified, dynamic and outcome oriented approaches to minimise the impact of these risks. Assets such as a diversified growth fund or multi-asset credit funds which aim to minimise market downturns whilst still capturing upside may be beneficial in this context.
Assets of this nature will become increasingly important as schemes mature and pay out more as the path of returns becomes more crucial. Falling behind the funding plan could be very painful, particularly in light of concerns around strength of sponsors and therefore covenants in the medium term. As a result, we advocate maintaining returns with downside considerations such as working an LDI mandate harder through several options such as active LDI, the use of absolute return bond funds for collateral or securities lending on gilts held in the portfolio. Another alternative, for those schemes willing to forgo some liquidity is a diversified portfolio of well-integrated alternatives, which may better protect schemes from market wobbles due to the idiosyncratic nature of these assets. These tricks of the trade may help schemes enjoy more funding level treats and fewer scares in the future.
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