“For UK DB pension schemes, May was strong and stable rather than weak and wobbly. UK schemes clawed back some gains over the calendar month – the PPF 7800 index climbed from 86% to 86.8%; a welcome improvement in the aggregate funding level but still shy of the 88.2% level reached at the start of the year. The UK equity market marched higher, meaning pension scheme assets rose by considerably more than liabilities – though largely due to higher earnings expectations given the Brexit-inspired drop in Sterling, rather than fundamental strength in UK equities.
“Indeed, Sterling volatility has characterized most of the last 12 months, as we approach the anniversary of the UK’s decision to leave the European Union. Though the currency has often acted as a ‘pressure valve’ through which UK economy and markets react to Brexit news flow, other markets have also been affected. Since the vote on the 23rd June last year, 10-year nominal and real gilt yields dropped almost 50 and 110 bps, respectively. Meanwhile UK equities are around 19% higher, largely driven by the aforementioned currency weakness.
“Following the referendum result we recommended that schemes increased their hedge ratios towards their long-term targets, in light of the ensuing uncertainty. The decision proved to be a shrewd one. If an 80% funded scheme, holding global equities and LDI, had fully hedged its liabilities at the end of last June, it’s funding ratio would be over five percent higher than an equivalent scheme using a classic 60/40 equity/bonds portfolio. Unfortunately, many schemes were far from 100% hedged a year ago and still are today, so most likely suffered sideways or falling funding levels given the ballooning liability values over the year.
“We don’t expect real yields to fall by the same magnitude in the years ahead. In fact, we foresee gilt yields rising over a five-year horizon as the global economy strengthens and monetary policy is normalized. However, we think the move higher in yields will be gradual and is not without downside risks, which is why recommend that pension schemes only modestly under-hedge their liabilities relative to their long-term target. Our cautious stance is driven by both structural factors and political uncertainty. Supply and demand factors for index-linked gilts are a powerful anchor on UK real yields that can’t be overlooked, and the political uncertainty posed by Brexit, which will weigh on the UK economy for years to come, could impact bond markets in unpredictable ways. As the UK comes to grips with the post-election results, there could well be additional twists and turns to come. Just as the Lions have discovered, taking a high risk:reward strategy, albeit entertaining, can equally come up short. Being more in control, taking measured risks and keeping the scoreboard ticking over steadily can prove to be a winning approach.”
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