Trustees and corporate sponsors across Europe remain focused on managing volatility in pension plan funding positions. According to Mercer’s annual European Asset Allocation Survey, schemes have continued to cut equity allocations. Rising equity markets over the course of 2012 and early 2013 have provided some investors with opportunities to bank gains and reduce equity exposure in response to improvements in their funding level.
The survey of more than 1,200 European pension funds with combined assets of over €750bn found that, in particular, plans in the UK had made a meaningful shift out of equities over the last 12 months, with the average equity allocation falling from 43% to 39% (the comparable figure was 68% in 2003). UK schemes have traditionally been among the most equity-heavy in Europe, but now sit behind Ireland, Belgium and Sweden in terms of equity exposure.
Mercer’s research also found that the proportion of schemes across Europe that allocate some part of their assets to a liability hedging (or LDI) mandate increased from 15% to 26% over the last year, with such strategies becoming commonplace in the UK and the Netherlands. Nearly half of the schemes surveyed also now have an allocation to alternatives, with around 75% of UK schemes claiming an alternatives allocation.
Pat Race, UK Head of Mercer Investments, said: “Against a backdrop of ultra-loose monetary policy, negative real interest rates and a range of unsolved economic issues, pension plans are faced with the challenge of generating positive real returns, while reducing funding level volatility. In response, investors are expanding their investment tool-kit, making their strategy more dynamic, and are introducing scenario and stress test analysis into the risk management process.”
Breadth and dynamism in alternatives portfolios
The range of alternative asset classes to which European pension plans allocate a portion of their assets continues to grow with each passing year. For example, real asset portfolios are moving beyond traditional property mandates to include long-lease property, infrastructure, timberland and agriculture.
Almost 20% of schemes across Europe now have an allocation to growth-oriented fixed income, with emerging market debt and high yield debt the most popular asset classes within this category. However, as the yields available across the credit spectrum have fallen, schemes have been moving towards senior loans and private debt, where the returns on offer remain attractive. This is primarily attributed to bank deleveraging across Europe.
Diversified Growth Funds (DGFs) have become a popular means of accessing a diversified exposure to a range of return drivers, while also introducing a degree of dynamism into asset allocation. Almost 20% of schemes now have an allocation to this type of strategy and interest levels show no sign of faltering.
Nick Sykes, European Director of Consulting in Mercer’s Investments business, said: “We see two themes emerging in the way that pension schemes approach alternative investments. First, low governance investors are attracted to broadly diversified and relatively liquid approaches that allow them to delegate dynamic asset allocation decisions to a fund manager with the necessary skill set. This is reflected in the trend towards DGFs by small and medium-sized pension schemes. Second, larger schemes with greater resources are increasingly keen to allocate directly to diversifying sources of return; such as agriculture, natural resources, insurance-linked securities and managed futures.”
Trends for the future
The trend away from equity assets looks set to continue over the coming year, with around 30% of schemes suggesting that they expect to reduce their domestic allocation and almost a quarter of schemes expecting to reduce their non-domestic equity exposure. Conversely, schemes look set to increase allocations to inflation-linked bonds, corporate bonds and LDI strategies in order to manage liability-relative risks.
Around a quarter of respondents suggested that they expect to increase their allocation to alternatives, with only 7% expecting to reduce the size of the portfolio. Within the alternatives portfolio there remains appetite for growth fixed income assets and multi-asset portfolios, and in particular DGFs.
Mr Sykes, said: “Pension schemes across Europe, but particularly in the UK, remain on a path towards a lower-risk investment strategy. However, the approach to reducing risk will not simply mean increases to government bond allocations and simple swap strategies. Instead, increasing interest in assets that offer a relatively stable and inflation-sensitive income stream is anticipated, such as ground lease property and infrastructure. A broader approach to fixed income investing, to include buy and maintain corporate bond strategies and multi-asset credit funds, is also on the horizon. Sophisticated LDI strategies are also proving essential for providing a greater degree of flexibility and responsiveness to changing market conditions.”
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