By Kate Rickards
Recent concerns over the strength of the global economy and the resultant falls in international stock markets have again brought the health of UK pension schemes into focus.
The Pension Protection Fund (PPF) — the statutory body that acts as the back-stop for UK employees’ retirement savings — recently reported that the aggregate deficit of UK defined benefit pension schemes at the end of October was £262.5bn, with a funding ratio of 82.7%. This comes alongside greater pressure from The Pension Regulator on pension fund trustees and sponsors to aim to ensure that pension deficits can be trimmed or wiped out over time, even with cautious assumptions on asset returns and the prospect that interest rates will remain “low for longer”.
Scheme sponsors have often been unwilling or unable to increase contributions into schemes with deficits. A study by Barnett Waddingham[1] showed that in 2014 the UK’s largest FTSE 350 companies contributed less towards defined benefit pension schemes than at any point since 2009. In such circumstances, and with falling bond yields pushing down the discount rates used to calculate the present value of payments schemes expect to make, often the only solution is to make assets work harder to deliver strong long-term returns above inflation by taking on risk through a truly active equity strategy.
Breaking away from bonds
At this point in the cycle, many schemes would typically be considering raising their allocation to bonds and government bonds in particular. However, with yields at historic lows and heightened expectations that the US Federal Reserve will raise interest rates in the next few months, bond prices currently carry considerable risks and offer little in return. The uncertainty as to when rates will rise means that bond market volatility is likely to persist for some time. During the first half of 2015, for example, we saw a sudden spike in major government bond yields despite no significant rise in inflation expectations.
Employing a targeted approach
In relation to equities, studies[2] have shown that portfolio managers typically add value in their high conviction stock picks but often destroy value with the unintended underweight positions in the portfolio. Having more concentrated portfolios with assets focused in the managers’ best ideas should lead to better outcomes for clients. However, this means that investors need to be able to tolerate some short-term volatility in order to maximise the long-term investment gains required to boost their pension asset levels.
A truly global perspective is also important. Those who invest actively but restrict their fund manager to certain regions, countries or sectors are likely to see reduced long-term returns because at various stages they will probably be relatively over-valued with limited upside potential, as evidenced by the recent stock market corrections from record highs in the US and UK, for example. Those who invest passively are even more exposed to such equity market falls.
Emerging market companies in particular offer important long-term growth benefits – albeit typically with heightened short-term volatility – and with valuations currently close to record lows, the opportunities are significant. However, many schemes miss these potential rewards on offer by investing closer to home; according to the Towers Watson study[3], although it has halved since 1998, UK pension funds still have a very high 36% exposure to lower growth domestic equities. Investing the overseas portion of the equity portfolio in line with the MSCI All County World Index[4] would currently mean that emerging market equities would represent around 5% of an investor’s total equity exposure and about 2% of their total asset allocation, which is arguably far too low given the attractive risk-return profile.
Most investors with ambitious return targets or significant liabilities to meet should benefit from an allocation to a high alpha equity fund as part of a balanced portfolio, either alongside a diversified growth fund, which typically invests across different asset classes to seek to reduce risk, or other growth assets. This is particularly true for pension funds, which generally have a long-term investment horizon and greater tolerance for short-term volatility.
We believe a highly active, high conviction approach provides the best potential rewards over the long-term. This is something pension funds require now more than ever as funding gaps continue to grow and better returns are required from the assets they hold.
Kate Rickards is UK institutional client adviser at Skagen Funds
[1] Barnett Waddingham, Impact of pension schemes on UK business – August 2015
[2] Inalytics, Track Records: Luck or Judgement? Introducing Hit Rates & Win Loss Ratios – Winter 2008
[3] Towers Watson, Global Pension Assets Study 2015 – February 2015
[4] Morningstar (MSCI ACWI market breakdown: 93% Developed Markets / 7% Emerging Markets as at 13/10/15)
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