In a month which includes fireworks and Thanksgiving, there was plenty of action but also reasons for UK Pension Schemes to be thankful in November, with PPF 7800 Index funding levels increasing over the month. This was despite a fall in asset values as equity market volatility experienced in October continued throughout November although less significantly, with the FTSE All Share Index ending the month down 1.6%. Schemes with more global exposure were saved somewhat by positive overseas equity performance. Despite this, most equity markets remain in negative territory for the year, something which has tempered funding level increases, despite the recently released 2018 Purple Book suggesting UK DB schemes’ equity allocations have fallen to new lows (27% in 2018 vs. 53.6% 10 years ago).
The most significant reason for the funding level improvement over November was liabilities falling by 5.4%, primarily driven by the PPF’s use of updated assumptions, contributing -5.1% of the change. This brings PPF funding levels into surplus on average, at 100.9%. Nevertheless with over 3,000 schemes still in deficit, trustees are not out of the woods yet and even those schemes in surplus are still likely to be some way from self-sufficiency. The latter should be focusing on capturing these gains and considering de-risking, whether by trimming their growth assets, increasing hedging and/or more closely matching their cashflows.
Longer-dated bonds fell in value over November and are down year-to-date, and it appears we will see both equities and bonds fall over the calendar year for only the second time in 30 years. Never has the case for alternative assets been more relevant, to boost returns through the illiquidity premium and diversify exposures, but still schemes have less than 10% allocated to these assets according to the 2018 Purple Book.
November also saw credit spreads widening which has increased the opportunities available for schemes seeking income. While declining as a proportion of schemes’ bond holdings, credit allocations remain significant at nearly 20% of overall asset allocation according to the 2018 Purple Book. However, schemes should be careful of buying corporate bond funds and then forgetting about them. Over the last 10 years corporate bond indices have experienced significant “feature drift”: In 2008, 16% of the ICE BofAML Sterling Corporate Index was BBB-rated; today it’s over 50%. The majority of the BBB-rated issuers of 2008 were industrials; in 2018 along with industrials, financials and utility companies now make up a large portion, many of which are highly leveraged. Credit investors may now own a very different mix of bonds than they did when they made their initial investment, and therefore different sector concentration and credit rating profiles than anticipated. We advocate trustees to review their credit portfolios to ensure these remain appropriate for their scheme’s objectives.
Finally with breakeven (expected) inflation nearing 3.5% at the long end of the yield curve, we see opportunities for schemes to separate their hedging decisions and consider reviewing their inflation hedging, particularly if using secure income assets to gain exposure to inflation in other places. In our view, the high breakeven rate is driven more by supply and demand factors with limited issuance of index-linked gilts expected in 2019, rather than a fear of rising inflation. Above all our message to trustees is clear: know what’s in your LDI and bond portfolios, build resilience into your strategy and diversify your growth assets to ensure your scheme is in good shape for whatever 2019 throws at it.
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