Pension funds should look at corporate bonds or annuity “buy-ins” to mitigate the potential impact of the new round of quantitative easing (QE), says Mercer. However, the consultancy also warns that caution is required to ensure the correct timing and long-term impact.
For schemes which hold gilts to match their pensioner liabilities, QE has pushed down yields on these holdings, effectively reducing future returns. This is prompting many schemes to reconsider their holdings or determine a new strategy to improve yields without materially increasing risk. Some schemes are looking to enhance returns by using corporate bonds instead, while others are investigating the purchase of a bulk annuity policy, commonly known as a buy-in, from an insurer.
Stuart Benson, Partner in Mercer’s Financial Strategy Group, said: “The pricing of corporate bonds presently looks attractive relative to gilts, even after allowing for default risk. In an insurance transaction, pricing can also be attractive relative to gilts, and the risk of increased costs from rising pensioner longevity is insured as part of the buy-in package. There are clearly some attractions to both routes. However, these decisions are more complex than they might look".
Mercer points out that corporate bond yields look attractive relative to gilts but the typical bond matures in 10 to 15 years compared with the gilts held by pension schemes which typically mature much later. By simply switching from one to the other, a scheme might be enhancing short to medium term returns, but increasing the risk of having inadequate assets in the longer term. This is because it is impossible to predict accurately what returns are expected once the corporate bond portfolio matures. In addition, unlike index-linked gilts, most corporate bonds do not offer inflation risk protection, so, even after considering default and duration risks, selling index-linked gilts to purchase corporate bonds could also lead to increased risks overall.
That said, there are solutions to both problems, believes Mercer. Sophisticated investors can use the derivatives markets to provide equivalent duration and inflation protection. Smaller schemes can achieve broadly the same outcome via pooled offerings from investment managers.
There are similar considerations for those considering the purchase of a bulk annuity policy, says David Ellis, Principal at Mercer.
"Insurance pricing varies significantly between insurers, from scheme to scheme and over time. Industry-wide effects such as QE will help identify potential opportunities,” he said “but it is each scheme's particular circumstances which determine whether an insurance-based strategy is really the best option at the time. A rush to a bulk annuity at the wrong time may prove to be more costly than getting the basics into place first. For instance, we know from our wide experience that good quality data will improve insurer pricing so it is worth taking urgent action to get the scheme data accurate, complete and up to date. Schemes can then get accurate, competitive quotations, and look at the alternatives such as corporate bonds before proceeding down a bulk annuity path.
"With present low gilt yields, schemes are now increasingly recognising that, in the search for higher returns, the investment decision in relation to pensioners has to involve – as a minimum - comparing gilts with corporates, and comparing both strategies with buy-in policies,” concluded Stuart Benson. Given corporate bond yields and insurer pricing, it is definitely a good time to consider these potential alternatives alongside the traditional gilt route.”
|
